Macroec I

Reading Materials Macroeconomics- I and II (Econ-221 and 222)
Chapter-I
Introduction to Macroeconomics
1.1 What Macroeconomics is about?
Economics is the study of the economy and the behaviour of people in the economy.
Traditionally, economics is divided into microeconomics, which studies the behaviour of
individuals and organizations (consumers, firms and the like) at a disaggregated level, and
macroeconomics, which studies the overall or aggregate behaviour of the economy. Since our
interest here is with macroeconomics, we seek to explain phenomena such as inflation,
unemployment, and economic growth and we are not concerned with, say, the demand for or
supply of a specific commodity. Macroeconomics is concerned with the behaviour of the
economy as a whole- with booms and recessions, the economy’s total output of goods and
services and the growth of output, the rate of inflation and unemployment, the balance of
payments, and exchange rates. Macroeconomics focuses on the economic behaviour and policies
that affect consumption and investment, trade balance, the determinants of changes in wages
and prices, monetary and fiscal policies, the money stock, government budget, interest rate, and
national debt. In macroeconomics, we do two things. First, we seek to understand the economic
functioning of the world we live in; and, second, we ask if we can do anything to improve the
performance of the economy. That is, we are concerned with both explanation and policy
prescriptions. Explanation involves an attempt to understand the behaviour of economic
variables, both at a moment in time and as time passes. Modern macroeconomics recognizes
that it is important to focus on more than just short period of time, and so has an explicitly
dynamic focus. We thus try to explain the behaviour of economic variables over time. This
means that we wish to explain the behaviour of the economic both in the long run and in the
short run.
1.2 The State of Macroeconomics: Evolution and Recent Developments
Schools of thoughts in Macroeconomics

Classical 1776 – 1870. In this period the distinction between micro and macro was not
clear. The ruling principle was the invisible hand coined by Alfred Marshall. The classicals have
made an ample contribution to the development of economic science. With regard to the labor
market, they contend that labor demand and labor supply are brought into equilibrium by the
real wage. As a result there is no involuntary unemployment. With regard to the financial
market, for classicals saving and investment are brought into equilibrium by the interest rate and
investment respond to the interest rate. In the money market, money demand is simply a
transaction demand and money has no any effect on the real economy and hence raising the
money supply simply pushes up prices (i.e. inflationary). The implication is that, government has
no any role in the economy through its monetary policy. To this end, the classicals are the
proponents of laissez-faire (no government role). In general, for this school markets (be it,
commodity, factor, and money) works best if left to them selves.
Neo classical 1870 – 1936. Basically the neoclassical school is not different from the
classical school. The main distinction is the tool of analysis, such as the marginal analysis.
Instructor: Getachew A. Department of Economics, Arba Minch University 1

Keynesian 1936 – 1970s. The main thesis of the Keynesian stream is that the economy is
subjected to failure so that it may not achieve full employment level. Thus, government
intervention is inevitable. This school views the labor market in that workers and firms bargain
for a money wage, not for real wage. Money wages adjust slowly and workers resist any drop in
the money wage. Unlike the classicals, for Keynesians saving and investment are brought into
equilibrium by changes in income. Investment is not influenced by a mere change in interest
rate; rather it is affected by expectations of the future, which is uncertain. Money demand is
affected by transactions, but also by other things, in particular fear, which may lead to a
“speculative demand” for high money balances. With regard to the role of the government,
Keynes argued that the government role was needed to preserve capitalism because with out
management, a modern capitalist economy is so unstable that it may threaten the social compact
that it rests on.
1970s – present. There is no dominant school of thought of macroeconomics. There have
been two main intellectual traditions in macroeconomics. One school of thought believes that
government intervention can significantly improve the operation of the economy; the other
believes that markets work best if left to themselves. In the 1960s, the debate on these questions
involved Keynesians, including Franco Modigliani and James Tobin, on one side, and
monetarists, led by Milton Friedman, on the other. In the 1970s, the debate on much the same
issues brought to the fore a new group- the 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 the new Keynesians; they may not
share many of the detailed belief of Keynesians three or four decades ago, except the belief that
government policy can help the economy perform better.
Keynesian’s View of the Economy1

In a very simplified form we can present Keynes’s theory of recessions. Imagine an economy
that is chugging along happily at full employment. Alongside the smoothly functioning ‘real’
economy there will be a smooth financial flows, as firms earn money from their sales, pay out
their earnings in wages and dividends, and household spend these receipts on new purchases
from the firms. But now suppose that for some reason each household and firm in this economy
decides that it would like to hold a little more cash. Keynes argued, in particular, this happens
when businessmen lose confidence and start to think of potential investments as risky, leading
them to hesitate and accumulate cash instead; today we might add the problem of nervous
households who worry about their jobs and cut back on purchases of big-ticket consumer items.
Either way, each individual firm or household tries to increase its holdings of cash by cutting its
spending so that its receipts exceed its outlays. But as Keynes pointed out, what works for an
individual does not work for the economy as a whole, because the amount of cash in the
economy is fixed. An individual can increase her cash holding by spending less, but she does so
only by taking away cash that other people had been holding. Obviously, not everybody can do
this at the same time. So what happens when everyone tries to accumulate cash simultaneously?
The answer is that income falls along with spending. I try to accumulate cash by reducing my
purchases from you, and you try to accumulate cash by reducing your purchases from me; the
result is that both of our incomes fall along with our spending, and neither of us succeeds in
increasing our cash holdings. If we remain determined to hold more cash, we will react to this
disappointment by cutting our spending still further, with the same disappointing result; and so
on and so on. Looking at the economy as a whole, you will see factories closing, workers laid
off, stores empty, as firms and households throughout the economy cut back on spending in a

collectively vain effort to accumulate more cash. The process only reaches a limit when incomes
are so shrunken that the demand for cash falls to equal the available supply.
Keynes and Economic Policy

For Keynes to do about recessions, the first and most obvious thing to do is to make it possible
for people to satisfy their demand for more cash without cutting their spending, preventing the
downward spiral of shrinking spending and shrinking income. The way to do this is simple to
print more money, and somehow get it into circulation. So the usual and basic Keynesian answer
to recessions is a monetary expansion. But Keynes worried that even this might sometimes not
be enough, particularly if a recession had been allowed to get out of hand and become a true
depression. Once the economy is deeply depressed, households and especially firms may be
unwilling to increase spending no matter how much cash they have; they may simply add any
monetary expansion to their hoarding. Such a situation, in which monetary policy has become
ineffective, has come to be known as a “liquidity trap”. In such a case, the government has to
do what the private sector will not: spend. When monetary expansion is ineffective, fiscal
expansion must take its place. Such a fiscal expansion can break the vicious circle of low
spending and low incomes and getting the economy moving again. Despite the "synthesis" and
the "consensus", however, Keynesian macroeconomics was subject to ongoing criticism, some
of it from academic economists who were uncomfortable with its theoretical foundations and
more of it from economists and others who did not like its political implications. By the 1970s,
changing economic circumstances and a shift in political opinion, both common to most of the
developed, industrial democracies, brought this criticism out into the open and a major attack
was launched against the Keynesian orthodoxy. Particularly influential in this was the experience
of unusually high (for "peacetime") rates of inflation conjoined with rising levels of
unemployment. Once consequence of this was a significant restatement of Keynesian principles
in a model designed to accommodate the possibility of changing price levels. This modified
"Keynesian" macro model appears in some form or other in nearly all introductory texts in
economics today.
Monetarism
Monetarism, as advocates of free market, started challenging Keynes’s theory in the 1970s.
Milton Friedman, the founder of monetarism, attacked Keynes idea of smoothing business cycle
on the ground that such active policy is not only unnecessary but actually harmful, worsening the
very economic instability that it is supposed to correct, and should be replaced by simple,
mechanical monetary rules. This is the doctrine that came to be known as “monetarism.”
Friedman began with a factual claim: most recessions, including the huge slump that initiated the
Great Depression, did not follow Keynes’s script. That is, they did not arise because the private
sector was trying to increase its holdings of a fixed amount of money. Rather, they occurred
because of a fall in the quantity of money in circulation. With regard to the labor market, while
not putting forward his own theory of the labor market, Friedman argues that people do tend to
think in real terms and not in nominal amounts. Friedman had a strong faith in the ability of the
private sector to produce growth and stability if it is not constrained by government. Friedman is
a libertarian, opposed to government interference on principle. He is both more optimistic than
Keynes about the inherent stability of capitalism, and much more suspicious of the state.

Policy Rule under Monetarism
If economic slumps begin when people spontaneously decide to increase their money holdings,
then the monetary authority must monitor the economy and pump money in when it finds a
slump is imminent. If such slumps are always created by a fall in the quantity of money, then the
monetary authority need not monitor the economy; it need only make sure that the quantity of
money doesn’t slump. In other words, a straightforward rule- “Keep the money supply steady”-
is good enough, so that there is no need for a “discretionary” policy of the form, “Pump money
in when your economic advisers think a recession is imminent.” Thus, for Monetarists,
depressions were the consequence of a temporary shortage of money and this implied that
monetary policy was of prime importance in determining the aggregate level of output and
employment.
The New Classical School

The new classical macroeconomics remained influential in the 1980s. This school of
macroeconomics 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, it is claimed, is likely only to make things worse by intervening.
The central working assumptions of the new classical school are three:
• Economic agents maximize. Households and firms make optimal decisions given all available
information in reaching decisions and that those decisions are the best possible in the
circumstances in which they find themselves.
• Expectations are rational, which means they are statistically the best predictions of the future
that can be made using the available information. Rational expectations imply that people will
eventually come to understand whatever government policy 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, market clear. For instance, any unemployed person who really
wants a job will offer to cut this or her wage until the wage is low enough to attract an offer
from some employer. Similarly, anyone with an excess supply of goods on the shelf will cut
prices so as to sell. The essence of the new classical approach is the assumption that markets are
continuously in equilibrium.
The New Keynesians
New Keynesian economics is the school of thought in modern macroeconomics that evolved
from the ideas of John Maynard Keynes. Keynes wrote The General Theory of Employment, Interest,
and Money in the thirties, and his influence among academics and policymakers increased through
the sixties. In the seventies, however, new classical economists such as Robert Lucas, Thomas J.
Sargent, and Robert Barro called into question many of the precepts of the Keynesian
revolution. The label "new Keynesian" describes those economists who, in the eighties,
responded to this new classical critique with adjustments to the original Keynesian tenets.
The new classical group remains highly influential in today’s macroeconomics. But a new
generation of scholars, the new Keynesians, mostly trained in the Keynesian tradition but

moving beyond it, emerged in the 1980s. 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 wage not only reduce the cost of
labor but are likely to wind up with a poorer quality labor. Thus they will be reluctant to cut
wages.
The primary disagreement between new classical and new Keynesian economists is over how
quickly wages and prices adjust. New classical economists build their macroeconomic theories
on the assumption that wages and prices are flexible. They believe that prices "clear" markets—
balance supply and demand—by adjusting quickly. New Keynesian economists, however, believe
that market-clearing models cannot explain short-run economic fluctuations, and so they
advocate models with "sticky" wages and prices. New Keynesian theories rely on this stickiness
of wages and prices to explain why involuntary unemployment exists and why monetary policy
has such a strong influence on economic activity.
A long tradition in macroeconomics (including both Keynesian and monetarist perspectives)

emphasizes that monetary policy affects employment and production in the short run because
prices respond sluggishly to changes in the money supply. According to this view, if the money
supply falls, people spend less money, and the demand for goods falls. Because prices and wages
are inflexible and don't fall immediately, the decreased spending causes a drop in production and
layoffs of workers. New classical economists criticized this tradition because it lacked a coherent
theoretical explanation for the sluggish behavior of prices. Much new Keynesian research
attempts to remedy this omission.
Menu Costs and Aggregate-Demand Externalities
One reason that prices do not adjust immediately to clear markets is that adjusting prices is
costly. To change its prices, a firm may need to send out a new catalog to customers, distribute
new price lists to its sales staff, or in the case of a restaurant, print new menus. These costs of
price adjustment, called "menu costs," cause firms to adjust prices intermittently rather than
continuously.
Economists disagree about whether menu costs can help explain short-run economic
fluctuations. Skeptics point out that menu costs usually are very small. They argue that these
small costs are unlikely to help explain recessions, which are very costly for society. Proponents
reply that small does not mean inconsequential. Even though menu costs are small for the
individual firm, they could have large effects on the economy as a whole.
Proponents of the menu-cost hypothesis describe the situation as follows. To understand why
prices adjust slowly, one must acknowledge that changes in prices have externalities—that is,
effects that go beyond the firm and its customers. For instance, a price reduction by one firm
benefits other firms in the economy. When a firm lowers the price it charges, it lowers the
average price level slightly and thereby raises real income. (Nominal income is determined by the

money supply.) The stimulus from higher income, in turn, raises the demand for the products of
all firms. This macroeconomic impact of one firm's price adjustment on the demand for all other
firms' products is called an "aggregate-demand externality."
In the presence of this aggregate-demand externality, small menu costs can make prices sticky,
and this stickiness can have a large cost to society. Suppose that General Motors announces its
prices and then, after a fall in the money supply, must decide whether to cut prices. If it did so,
car buyers would have a higher real income and would, therefore, buy more products from other
companies as well. But the benefits to other companies are not what General Motors cares
about. Therefore, General Motors would sometimes fail to pay the menu cost and cut its price,
even though the price cut is socially desirable. This is an example in which sticky prices are
undesirable for the economy as a whole, even though they may be optimal for those setting
prices.
The Staggering of Prices
New Keynesian explanations of sticky prices often emphasize that not everyone in the economy
sets prices at the same time. Instead, the adjustment of prices throughout the economy is
staggered. Staggering complicates the setting of prices because firms care about their prices
relative to those charged by other firms. Staggering can make the overall level of prices adjust
slowly, even when individual prices change frequently.
Consider the following example. Suppose, first, that price setting is synchronized: every firm
adjusts its price on the first of every month. If the money supply and aggregate demand rise on
May 10, output will be higher from May 10 to June 1 because prices are fixed during this
interval. But on June 1 all firms will raise their prices in response to the higher demand, ending
the three-week boom.
Now suppose that price setting is staggered: Half the firms set prices on the first of each month
and half on the fifteenth. If the money supply rises on May 10, then half the firms can raise their
prices on May 15. Yet because half of the firms will not be changing their prices on the fifteenth,
a price increase by any firm will raise that firm's relative price, which will cause it to lose
customers. Therefore, these firms will probably not raise their prices very much. (In contrast, if
all firms are synchronized, all firms can raise prices together, leaving relative prices unaffected.)
If the May 15 price setters make little adjustment in their prices, then the other firms will make
little adjustment when their turn comes on June 1, because they also want to avoid relative price
changes. And so on. The price level rises slowly as the result of small price increases on the first
and the fifteenth of each month. Hence, staggering makes the price level sluggish, because no
firm wishes to be the first to post a substantial price increase.
Coordination Failure
Some new Keynesian economists suggest that recessions result from a failure of coordination.
Coordination problems can arise in the setting of wages and prices because those who set them
must anticipate the actions of other wage and price setters. Union leaders negotiating wages are
concerned about the concessions other unions will win. Firms setting prices are mindful of the
prices other firms will charge.

To see how a recession could arise as a failure of coordination, consider the following parable.
The economy is made up of two firms. After a fall in the money supply, each firm must decide
whether to cut its price. Each firm wants to maximize its profit, but its profit depends not only
on its pricing decision but also on the decision made by the other firm.
If neither firm cuts its price, the amount of real money (the amount of money divided by the
price level) is low, a recession ensues, and each firm makes a profit of only fifteen dollars.
If both firms cut their price, real money balances are high, a recession is avoided, and each firm
makes a profit of thirty dollars. Although both firms prefer to avoid a recession, neither can do
so by its own actions. If one firm cuts its price while the other does not, a recession follows. The
firm making the price cut makes only five dollars, while the other firm makes fifteen dollars.
The essence of this parable is that each firm's decision influences the set of outcomes available
to the other firm. When one firm cuts its price, it improves the opportunities available to the
other firm, because the other firm can then avoid the recession by cutting its price. This positive
impact of one firm's price cut on the other firm's profit opportunities might arise because of an
aggregate-demand externality.
What outcome should one expect in this economy? On the one hand, if each firm expects the
other to cut its price, both will cut prices, resulting in the preferred outcome in which each
makes thirty dollars. On the other hand, if each firm expects the other to maintain its price, both
will maintain their prices, resulting in the inferior solution, in which each makes fifteen dollars.
Hence, either of these outcomes is possible: there are multiple equilibria.
The inferior outcome, in which each firm makes fifteen dollars, is an example of a coordination
failure. If the two firms could coordinate, they would both cut their price and reach the
preferred outcome. In the real world, unlike in this parable, coordination is often difficult
because the number of firms setting prices is large. The moral of the story is that even though
sticky prices are in no one's interest, prices can be sticky simply because people expect them to
be.
Efficiency Wages
Another important part of new Keynesian economics has been the development of new theories
of unemployment. Persistent unemployment is a puzzle for economic theory. Normally,
economists presume that an excess supply of labor would exert a downward pressure on wages.
A reduction in wages would, in turn, reduce unemployment by raising the quantity of labor
demanded. Hence, according to standard economic theory unemployment is a self-correcting
problem.
New Keynesian economists often turn to theories of what they call efficiency wages to explain
why this market-clearing mechanism may fail. These theories hold that high wages make workers
more productive. The influence of wages on worker efficiency may explain the failure of firms to
cut wages despite an excess supply of labor. Even though a wage reduction would lower a firm's
wage bill, it would also—if the theories are correct—cause worker productivity and the firm's
profits to decline.

There are various theories about how wages affect worker productivity. One efficiency-wage
theory holds that high wages reduce labor turnover. Workers quit jobs for many reasons—to
accept better positions at other firms, to change careers, or to move to other parts of the
country. The more a firm pays its workers, the greater their incentive to stay with the firm. By
paying a high wage, a firm reduces the frequency of quits, thereby decreasing the time spent
hiring and training new workers.
A second efficiency-wage theory holds that the average quality of a firm's work force depends
on the wage it pays its employees. If a firm reduces wages, the best employees may take jobs
elsewhere, leaving the firm with less productive employees who have fewer alternative
opportunities. By paying a wage above the equilibrium level, the firm may avoid this adverse
selection, improve the average quality of its work force, and thereby increase productivity.
A third efficiency-wage theory holds that a high wage improves worker effort. This theory posits
that firms cannot perfectly monitor the work effort of their employees and that employees must
themselves decide how hard to work. Workers can choose to work hard, or they can choose to
shirk and risk getting caught and fired. The firm can raise worker effort by paying a high wage.
The higher the wage, the greater is the cost to the worker of getting fired. By paying a higher
wage, a firm induces more of its employees not to shirk and, thus, increases their productivity.
Policy Implications
Because new Keynesian economics is a school of thought regarding macroeconomic theory, its
adherents do not necessarily share a single view about economic policy. At the broadest level
new Keynesian economics suggests—in contrast to some new classical theories—that recessions
do not represent the efficient functioning of markets. The elements of new Keynesian
economics, such as menu costs, staggered prices, coordination failures, and efficiency wages,
represent substantial departures from the assumptions of classical economics, which provides
the intellectual basis for economists usual justification of laissez-faire. In new Keynesian theories
recessions are caused by some economy-wide market failure. Thus, new Keynesian economics
provides a rationale for government intervention in the economy, such as countercyclical
monetary or fiscal policy. Whether policymakers should intervene in practice, however, is a more
difficult question that entails various political as well as economic judgments.
Concluding Remark
All school of macroeconomics agree on the purpose of macro policy but they disagree on how
to achieve the macro objectives of higher output, lower level of unemployment and inflation
rate.
Recent Developments in Macroeconomics: Breaking of the consensus

Fifteen or twenty years ago, it was much easier being a student of macroeconomics.
Macroeconomists felt more sure of the answers they gave to questions such as “what causes
output and employment to fluctuate?” and “what is the correct policy response to these
fluctuations?” The accepted models were either the IS-LM model that takes prices as given or
the Phillips curve that had a natural rate property, allowing the economy to be self correcting in
the long run. Today macroeconomists are much less sure of their answers.

The consensus in macroeconomics that prevailed until the early 1970s, therefore, faltered for
two reasons, one empirical and one theoretical. The empirical reason is that the consensus view
didn’t adequately cope with the rising rates of inflation and unemployment experienced during
the 1970s. The theoretical reason is that the chasm between microeconomic principles and
macroeconomic practice was too great to be intellectually satisfying.
These two reasons came together most obviously and most profoundly in the famous prediction
of Milton Friedman (1968) and Edmund Phelps (1968). According to unadorned Phillips curve,
one could maintain a permanently low level of unemployment merely by tolerating a
permanently high level of inflation. In the late 1960s, when the consensus view was still in
heyday, Freidman and Phelps argued from microeconomic principles that this empirical
relationship between inflation and unemployment would break down if policy makers attempted
to exploit it. After all, the equilibrium level of unemployment should depend on labor supply,
labor demand, optimal search times, and other microeconomic considerations, not on the
average growth rate of money. Subsequent events proved Friedman and Phelps correct, as
inflation rose with out any permanent reduction in unemployment.
The breakdown of the Phillips curve and the precedence of Friedman and Phelps made
macroeconomists ready for Robert Lucas’s (1976) more comprehensive attack on the consensus
view. Lucas pointed out that many of the empirical relationships that make up the large scale
macro econometric models were no better founded on microeconomic principles than was the
Phillips curve. In particular, the decisions that determine most macroeconomic variables, such as
consumption and investment, depend crucially on expectations of the future state of the
economy. Macroeconometric models treated expectations in a very cavalier way most often
making up plausible but arbitrary proxies. Lucas pointed out that an important feature of most
policy interventions is that they change the way individuals form expectations about future. Yet
the proxies for expectations used in the macroeconometric models failed to take account of this
feature. Lucas concluded, therefore, that these models should not be used to evaluate the impact
of alternative policies.
1.3. Basic Concepts and Methods of Macroeconomic Analysis

a. Measuring the Value of Economic Activity: Gross Domestic Product
The single most important measure of overall economic performance is Gross Domestic
Product (GDP). The GDP is an attempt to summarize all economic activity over a period of
time in terms of a single number; it is a measure of the economy’s total output and of total
income. In other words GDP is the value of all final goods and services produced in the
economy in a given time period (note that GDP is a flow not a stock).
Real GDP versus Nominal GDP

Valuing goods at their market price allows us to add different goods into a composite measure,
but also means we might be misled into thinking we are producing more if prices are rising.
Thus, it is important to correct for changes in prices. To do this, economists value goods at the
prices at which they sold at in some given year. For example, in Ethiopia, we mostly measure
GDP at 1980/81 prices. This is known as real GDP. GDP measured at current prices is known
as nominal GDP.

.
GDP and GNP
There is a distinction between GDP and gross national product (GNP). GNP is the value of
final goods and services produced by domestically owned factors of production within a given
period. The difference between GDP and GNP corresponds to the net income earned by
foreigners. When GDP exceeds GNP residents of a given country are earning less abroad than
foreigners are earning in that country. In Ethiopia, GDP has exceeded GNP since 1981 (based
on the data available in World Development Indicators CD-ROM, 2000) but the gap is well
below 1% (0.75% to be exact) during 1981 – 1998. In simple words, GDP is territorial while
GNP is national.
Gross and Net Domestic Product

Capital wears out, or depreciates while it is being used to produce output. Net domestic product
(NDP) is equal to GDP minus the capital consumption allowance, a measure of depreciation.
GNP and welfare measurement
Traditionally, growth is measured as the relative change in GNP per capita. The basic idea is
that GNP per capita measures the current and the future per capita welfare. GNP equals (in
a closed economy) consumption plus gross investment. Current welfare is then measured by
current consumption, and the change in future consumption opportunities caused by current
saving –and- investment decisions is measured by current investments. Obviously, GNP is
not an appropriate measure of welfare. Besides the fact that it doesn’t incorporate equity
issues (both intra and intergenerational equity), it also suffers from other drawbacks. In this
connection, the following seems to be the most important failure:
• GNP is not a net concept. We are interested in net investment and therefore in
NNP.
• Conventional net investments do not include changes in most natural assets,
although they are indispensable for human welfare
• Consumption as conventionally measured does not include environmental
damage.
These and other perceived drawbacks of GNP as a welfare measure have created a number of
studies on how to redefine the standard National Accounts in order to improve the
informational content of NNP. In this connection Dasgupta and Maler (1991), Hartwick (1990,
1992) and Maler(1991) have tried to develop a theoretical framework for accounting system. It
turns out that the ‘correct’ measure should be constructed as follows:
NNP = consumption
- current environmental damage
+ Net investment in real capital
+ Net change in the value of Human capital
+ Net change in the value of the stock of natural capital

The Business Cycle and the Output Gap

Inflation, growth, and unemployment are related through the business cycle. The business cycle
is the more or less regular pattern of expansion (recovery) and contraction (recession) in
economic activity around the path of trend growth. At a cyclical peak, economic activity is high
relative to trend; and at a cyclical trough, the low point in economic activity is reached. Inflation,
growth, and unemployment all have clear cyclical patterns.
The trend path of GDP is the path GDP would take if factors of production were fully
employed. Over time, real GDP changes for the two reasons. First, more resources become
available which allows the economy to produce more goods and services, resulting in a rising
trend level of output. Second, factors are not fully employed all the time. Thus, output can be
increased by increasing capacity utilization. Output is not always at its trend level, that is, the
level corresponding to full employment of the factors of production. Rather output fluctuates
around the trend level. During expansion (or recovery) the employment of factors of production
increased, and that is a source of increased production. Conversely, during a recession
unemployment increases and less output is produced than can in fact be produced with the
existing resources and technology. Deviations of output from trend are referred to as the output
gap.
The output gap measures the gap between actual output and the output the economy could
produce at full employment given the existing resources. Full employment output is also called
potential output.
Output gap ≡ potential output – actual output
When looking at the business cycle fluctuation, one question that naturally arises is whether
expansions give way inevitably to old age, or whether they are instead brought to an end by
policy mistakes. Often a long expansion reduces unemployment too much; causes inflationary
pressures, and therefore triggers policies to fight inflation- and such policies usually create
recessions.
Okun’s Law
A relationship between real growth and changes in the unemployment rate is known as Okun’s
law, named after its discoverer, Arthur Okun. Okun’s law says that the unemployment rate
declines when growth is above the trend rate.

Inflation –Unemployment Dynamics: The Phillips Curve
The Phillips curve describes the empirical relationship between inflation and unemployment: the
higher the rate of unemployment, the lower the rate of inflation. The curve suggests that less
unemployment can always be attained by incurring more inflation and that the inflation rate can
always be reduced by incurring the costs of more unemployment. In other words the curve
suggests there is a trade-off between inflation and unemployment.
Case study: The Phillips curve for Ethiopia
Yohannes (2000), attempted to estimate the Phillips curve for Ethiopia by plotting the actual
rate of inflation against the rate of unemployment and conclude that the higher the
unemployment is the higher the inflation is. At least in the short run, inflation is positively
related with unemployment, i.e. there is no trade off between them. The traditional Phillips
curve is not therefore applicable to Ethiopia. The policy implication is that it is not wise for the
government to choose high unemployment in order to dampen inflation and vice versa. If it

chooses higher unemployment it may end up in higher inflation. Since the economy is
dominantly agrarian, characterized by production rigidities and market fragmentation,
government policy to manage the economy from the demand side wouldn’t be effective. The
only solution to fight against inflation is therefore to support the working of the supply side and
remove structural bottlenecks.
References:
Branson, W. (2002) Macroeconomics theory and Practice, AITBS publishers, Delhi
Dornbusch, R. , S. Fisher and R. Startz (2001) Macroeconomics, 2nd ed. McGraw hill, New
Delhi
Mankew, G.(2002). Macroeconomics, 5th ed., worth publishing
Mankew, G (1988). “Recent Developments in Macroeconomics: a very quick refresher course”.

Journal of Money, Credit and Banking, vol. 20 No. 3
Mankew, G (2002). “The New Keynesian Economics”. The Concise Encyclopedia of

Economics, the library of Economics and liberty. (internet doc.)
Yohaness Ayalew (2000). The trade off between Unemployment and Inflation in Ethiopia, (a
draft doc.)

Chapter-II
Aggregate Demand and Supply Analysis
2.1. Introduction: Income- Expenditure Approach
Some important identities
In this section an attempt will be made to have a look at on some important identities from a set
of national income relationships. For analytical work, we simplify our analysis by making
assumptions that ensure that disposable income is equal to GDP. For most of our discussion we
disregard depreciation and thus the difference between GDP and NDP as well as the difference
between gross investment and net investment. We refer simply to investment spending. We also
ignore taxes and any transfer payments. With these conventions in mind, we refer to national
income and GDP interchangeably as income or output. By omitting the government and the
foreign sector we will consider a simple closed economy model for our analysis.
A Simple Economy Model
The saving- investment balance

Assume an economy in which there is no government and foreign trade. In such a case national
income accounts divide total expenditure into two categories (Note that in the simplest form of a
circular flow, output is equals to income that in turn equals to expenditure.): Consumption (C) and
investment spending (I). The first key identity is that output produced equals output sold.
Output sold can be written in terms of the components of demand as the sum of consumption
and investment spending (note that we count the accumulation of inventories as part of
investment or as if the firms sold the goods to them selves to add to their inventories)
Accordingly, we can write the identity of output produced and output sold:

One can think of what lies behind this relationship in a variety of ways. In a very simple
economy, the only way the individual can save is by undertaking an act of physical investment.
In a slightly more sophisticated economy, one could think of investors financing their investing
by borrowing from individuals who save.
An Economy with Government and Foreign Trade
We now consider an economy with government sector and external sector and denote the
government purchases of all goods and services by (G) and its tax receipt by (TA). The
government also makes transfer to the private sector (TR). The foreign sector is composed on
imports (M) and exports (X). Net exports (exports minus imports) are denoted by NX.
The first term on the right-hand side (G+TR-TR) is the government budget deficit (BD) - i.e.
the excess of government spending over its receipts. The second term on the right-hand side is
the excess of exports over imports, or net exports.
Thus, identity (9) states that the excess of saving over investment (S – I) of the private sector is
equal to the government budget deficit plus the trade surplus. The identity suggests that there
are important relations among the excess of private saving over investment (S –I), the

government budget (BD), and the external sector. For instance, if, for the private sector, saving
is equal to investment, then the government’s budget deficit (surplus) is reflected in an equal
external deficit (surplus).
In the 1980s there was much discussion of the twin deficit- the budget deficit and the trade
deficit. Identity (9) is helpful is seeing that budget deficit must have a counterpart: if the
government spends more than it receives in revenue, then it has to borrow, either at home
(private saving exceeds investment) or abroad (imports exceeded exports). The identity makes it
clear that budget deficits need not be matched one-for-one by negative net exports.
Thus, there is no inevitable one-to-one link between the two deficits.
In general, any sector that spends more than it receives in income has to borrow to pay for
excess spending. The private sector has three ways of disposing of its saving.
• It can make loans to the government (for example in the form of bonds, treasury bills,
stocks etc.), where the government pays for the excess of its spending over the income it
receives from taxes.
• The private sector can lend to foreigners in case where they are buying more from us
than we are buying from them. They therefore are earning less from us, and we have to
lend to cover the difference.
• Or the private sector can lend to business firms, which use the funds for investment
(consider the case of Ethiopian Telecommunication Corporation’s recent announcement
of selling bonds to the private sector so that it can able to have funds for investment in
ITC development).
In all the above cases the private sector will be paid back later, receiving interest or dividends
in addition to the amount they lent)
Alternatively, we can also obtain another expression for the saving investment balance. Consider
a closed economy with government and the national income is given by
C+I+G =Y=C+S+T
Subtracting C from each side gives us:
Y-C=I+G=S+T
So that
I+G=S+T
By moving G to the right hand side we can arrive at
I= S+ (T-G)
Here I is total private investment, S is total private saving, and (T-G) is the government surplus,
which may be thought of as net government saving. The sum of private saving and the
government’s surplus must, by definition, equal private investment in the national income
accounts.

2.2. Aggregate Demand Analysis
2.2.1 The Goods Market and the IS Curve
2.2.1.1. The Keynesian Cross

To derive the Keynesian cross, we begin by looking at the determinants of planned expenditure
or planned aggregate demand. Planned expenditure (or planned aggregate demand) is the
amount of households, firms, and the government plan to spend on goods and services.
The difference between actual and planned expenditure is unplanned inventory investment.
When firms sell less of their product than planned, their stock of inventories automatically rises.
Conversely, when firms sell more than planned, their stock of inventories falls. Because these
unplanned changes in inventory are counted as spending by firms, actual expenditure can be
either above or below planned expenditure.
Assuming that the economy is closed, so that net exports are zero, we write planned aggregate
demand (or planned expenditure) AD as the sum of consumption (C), planned investment (I),
and government purchases G:

The figure above graphs planned expenditure as a function of the level of income since the other
variables are fixed. The line slopes upward because higher income leads to higher consumption
and thus higher planned expenditure. The slope of this line is the marginal propensity to
consume, the MPC: it shows how much planned expenditure increases when income rises by
one unit.
The Economy in Equilibrium
The economy is in equilibrium when actual aggregate demand equals planned aggregate demand.
Total output of the economy Y equals not only total income but also actual aggregate demand.
We can write the equilibrium condition as
Actual aggregate demand = Planned aggregate demand

Y= AD

In figure 2, the 45o line serves as a reference line that translates any horizontal distance into an
equal vertical distance. Thus, anywhere on the 45o line, the level of aggregate demand is equal to
the level of output. For instance, at point A, both output and aggregate demand are equal. The
equilibrium output would be achieved through inventory adjustment. Unplanned changes in
inventories induce firms to change production levels, which in turn changes income and
expenditure.
For example, suppose GDP is at a level greater than equilibrium level, such as level Y1 in figure
2, because of the miscalculation of firms about the aggregate demand. In this case, planned
aggregate demand AD1 is less than production (Y1). Firms are selling less than less than they
produce. Firms add the unsold goods to their stock of inventories. This unplanned rise in
inventories induces firms to lay off workers and reduce production, which reduce GDP. This
process of unintended inventory accumulation and falling income continues until income falls to
the equilibrium level. At the equilibrium, income equals planned aggregate demand.
Similarly, suppose GDP is at a level lower than the equilibrium level, such as the level Y2. In this
case, planned aggregate demand is AD2, which is more than output Y2. Because planned
aggregate demand exceeds production, firms are selling more than they are producing. As firms
see their stock of inventories fall, they hire more workers and increase production. This process
continues until income equals planned aggregate demand.
In summary, the Keynesian cross shows how income Y is determined for given levels of planned
investment (I) and fiscal policy G and T. We can use this model to show how income changes
when one of these exogenous variables changes.
2.2.1.2. Derivation of the multipliers

A. the expenditure multiplier
In order to make the analytics of the multiplier process as clear as possible, we begin with a case
−
where tax revenues are a fixed sum T . This is the tax revenue to be collected, regardless of the
level of income. In this case we have the basic equilibrium condition,
− − − − −
C(Y- T )+ I +G=Y= C(Y- T )+S(Y- T )+ T ------------- (1)
Subtracting C from all the equation gives us
− − − −
I +G=Y- C(Y- T )=S(Y- T )+ T ---------------------------(2)
To find the change in equilibrium income following the change in investment, we can
differentiate the left hand side of equation one above, holding G and T constant, to obtain
C’dY+dI=dY and dY(1-C’)=dI, so that the investment multiplier giving the change in
equilibrium income dY relative to the change in investment dI is
dY/dI=1/1-C’ =1/S’ since 1-C’=S’
What if tax is a function of income, i.e. tax revenues are an increasing function of income? In
this more realistic case, the basic equilibrium condition for income determination is
− −
C(Y- T (Y ) ) + I +G =Y= C(Y-T(Y)) +S(Y-T(Y)) +T(Y) --------- (3)
And subtracting C(Y-T(Y)) from each part of equation (3) gives us

I+G=Y- C(Y-T(Y)) = S(Y-T(Y)) +T(Y) ------------ (4)

Differentiating the left hand side of equation (3) will give us
dY=C’(dY-T’dY)+dI+dG
dY=C’.(1-T’)dY+dI+dG,
so that the multiplier expression is given by
dI + dG
dY= ----------------------(5)
1 − C ' (1 − T ' )
Equation (5) above tells us that introducing a tax function has reduced both expenditure and
government purchase multipliers.
B. Fiscal Policy and the Multiplier: Government Purchases multiplier
Since government purchases are one component of expenditure, high government purchases
imply, for any given level of income, higher planned aggregate demand. If government purchases
rise by ∆G, then the planned aggregate demand schedule shifts upward by ∆G, as shown in the
figure below.
The graph shows that an increase in government purchases leads to an even greater increase in
income. That is, dY > dG. The ratio ∆Y/∆G is called the government purchase multiplier; and
it tells how much income rises in response to a one-unit increase in government purchases. An
implication of the Keynesian cross is that the government purchases multiplier is larger than
one.
Why does fiscal policy have a multiplied effect on income? The reason is that, according to the
consumption function, higher income causes higher consumption. Because an increase in
government purchases raises income, it also raises consumption, which further raises
consumption, and so on. Therefore, in this model, an increase in government purchases causes a
greater increase in income.

The process of the multiplier begins when expenditure rises by ∆G, which implies that income
rises by ∆G as well. This increase in income in turn raises consumption by MPC* ∆G, where MPC
is the marginal propensity to consume. This increase in consumption raises aggregate demand
and income once again. This second increase in income of MPC * ∆G again raises consumption
by MPC* (MPC * ∆G), which again raises aggregate demand and income, and so on. We can
thus write this process compactly as

C. Fiscal Policy Multiplier: Tax multiplier

A decrease in taxes of ∆T immediately raises disposable income Y-T by ∆T and, therefore,
consumption by MPC * ∆T. For any level of income Y, aggregate demand is now higher. As
shown in the figure below, the aggregate demand schedule shifts upward by MPC*∆T. The
equilibrium of the economy moves from point A to point B.
D. Derivation of the Balanced Budget Multiplier

−
Recall the basic equilibrium condition (1) with taxes exogenous given as T ,
− −
Y= C(Y- T ) + I +G
− −
We can obtain a general expression giving changes in Y as a function of changes in T , I and G
by differentiating (1) to obtain
− −
dY=C’.(dY-d T )+d I +dG
− −
and dY.(1-C’)=-C’ d T + d I +dG
− C ' dT + dI + dG
so that dY= ----------------------(a)
1− C'

Equation (a) above is a general multiplier expression from which we can obtain the multiplier for
− − −
d I , by setting d T and dG equal to zero and divide by d I . The same multiplier would also
− −
apply to dG, holding T and I constant.
Suppose now we ask what happens to Y if we raise government purchases and tax revenues by
− −
the same amount, holding I constant. Substituting dG=d T into equation (a) above and setting
−
d I =0 gives us
dY= − C ' dG + dG =dG 1 − C ' ,
1− C' 1− C'
So that the balanced budget multiplier is given by
dY = 1 − C ' =1---------------------------- (b)

dG 1 − C '
Interpretation
−
Equation (c) tells us that an equal increase in T and G with investment fixed, leaves the
government surplus and deficit unchanged and increase income by the same amount of the
increase in G.
The Interest rate, Investment and the IS Curve
The Keynesian income determination model is useful because it shows what determines the
economy’s income for any given level of planned investment. Yet it makes the unrealistic
assumption that the level of planned investment is fixed. However, planned investment depends
negatively on the interest rate.
The transition from the Keynesian cross model to the IS curve is achieved by noting that if the
real interest rate changes, this changes planned investment. The Keynesian cross analysis tells us
that change in planned investment change GDP. Thus, for example, if interest rates increase,
planned investment falls, and so does output. Thus higher levels of the interest rate are
associated with lower level of output.
To add the relationship between the interest rate and investment, we write the level of planned
investment as
I = I(r).
Thus, we can write equation [1] as
Y = C (Y-T) +I(r) +G

We can now use the investment function and the Keynesian cross diagram to determine how
income changes when the interest rate changes. Because investment is inversely related to the
interest rate, an increase in the interest rate from r1 to r2 reduces the quality of investment form
I(r1) to I(r2). The reduction in planned investment, in turn, shifts the expenditure function
downward as shown in the upper panel of the figure above. The shift in the expenditure
function leads to a lower level of income. Hence, an increase in the interest rate lowers income.
The IS curve summarizes the relationship between the interest rate and the level of income that
results from the investment function and the Keynesian cross. The higher the interest rate, the
lower the level of planned investment, and thus the lower the level of income. For this reason
the IS curve slopes downward.
Alternative Derivation of the IS Curve
We can also derive the IS curve using the national income accounts identity- i.e.
[1] Y-C-G=I
S=I.
The identity states that saving equals to investment. The saving here represents the supply of
loanable funds, and investment represents the demand for these funds.
To see how the market for loanable funds produce the IS curve, substitute the consumption
function for C and the investment function for I:

How Fiscal Policy Shifts the IS Curve

The IS curve shows us the level of income for any given interest rate. The IS curve is drawn for
a given fiscal policy; that is, the IS curve holds G and T fixed. When fiscal policy changes, the IS
curve shifts.
This shows that for a given interest and tax rate, an increase in government spending will lead to
a higher level of output. This can be shown as a shift in the IS curve.

In summary, the IS curve shows the relationship between the interest rate and the level of
income that arises form the market for goods and services. The IS curve is drawn for a given
fiscal policy. Changes in fiscal policy that raise the demand for goods and services shift the IS
curve to the right. Changes in fiscal policy that reduce the demand for goods and services (such
as an increase in tax) shift the IS curve to the left.
2.2.2 The Money Market and the LM Curve

The LM curve is the relationship between the interest rate and the level of income that arises in
the market for money balances.
a. The Theory of Liquidity Preference

The theory of liquidity preference explains how the supply and demand for real money balance
determines the interest rate.
We begin with the supply of real money balances. If M stands for the supply of money and P
stands for the price level, then M/P is the supply of real money balances. The theory of liquidity
preference assumes there is a fixed supply of real balance. That is,
The money supply M is an exogenous policy variable chosen by the central bank. The price level
P is also an exogenous variable in this model. (We take the price level as given because the IS-
LM model considers the short run when the price level is fixed). These assumptions imply that
the supply of real balances is fixed and, in particular, does not depend on the interest rate as
shown in the figure below.
The money supply M is an exogenous policy variable chosen by the central bank. The price level
P is also an exogenous variable in this model. (We take the price level as given because the IS-
LM model considers the short run when the price level is fixed). These assumptions imply that
the supply of real balances is fixed and, in particular, does not depend on the interest rate as
shown in the figure below.

Next, consider the demand for real money balances. People hold money because it is a “liquid”
asset- that is, because it is easily used to make transactions. The theory of liquidity preference
postulates that the quantity of real money balances demanded depends on the interest rate. The
interest rate is the opportunity cost of holding money. When the interest rate rises, people want
to hold less of their wealth in the form of money.
We write the demand for real money balances as

(M/P)d = L(r).
Where the function L( ) denotes the demand for the liquid asset- money. This equation states
that the quantity of real balances demanded is a function of the interest rate. This inverse
relationship between money demand and interest rate can be shown as a downward sloping
demand curve.
To obtain the theory of the interest rate, we combine the supply and the demand for real money
balances. According to the theory of liquidity preference, the interest rate adjusts to equilibrate
the money market. At the equilibrium interest rate, the quantity of real balances demanded
equals the quantity supplied. The equilibrium condition is shown in the figure below.
The adjustment of the interest rate to this equilibrium of money supply and money demand
occurs because people try to adjust their portfolios of assets if the interest rate is not at the

equilibrium level. If the interest rate is too high, the quantity of real balances supplied exceeds
the quantity demanded. Banks and other financial institutes respond to this excess supply of
money by lowering the interest rates they offer. Conversely, if the interest rate is too low, so that
the quantity of money demanded exceeds the quantity supplied, individuals try to obtain money
by making bank withdrawals, which drives the interest rate up. At the equilibrium interest rate
people are content with their portfolios of monetary and non-monetary assets.
The theory of liquidity preference implies that decreases in the money supply raise the interest
rate and that increases in the money supply lower the interest rate. Suppose there is a reduction
in money supply. A reduction in M reduces M/P, since P is fixed in the model. The supply of
real balances shift to the left, as shown in the figure below. The equilibrium interest rate rises
from r1 to r2. The higher interest rate induces people to hold a smaller quantity of real money
balances.
Income, Money Demand, and the LM Curve
So far we have assumed that only the interest rate influences the quantity of real balances
demanded. More realistically, the level of income Y also affects money demand. When income is
high, expenditure is high, so people engage in more transactions that require the use of money.
Thus, greater income implies greater money demand. We now write the money demand function
as
(M/P) d = L(r, Y).
The quantity of real money balances demanded is negatively related to the interest rate and
positively related to income.
Using the theory of liquidity preference, we can see what happens to the interest rate when the
level of income changes. For example, consider what happens when income increases from Y1 to
Y2.

As the above figure shows the increase in income shifts the money demand curve outward. To
equilibrate the market for real money balances, the interest rate must rise from r1 to r2.
Therefore, higher income leads to a higher interest rate. The LM curve plots this relationship
between the level of income and the interest rate. The higher the level of income, the higher the
demand for real money balances, and the higher the equilibrium interest rate. For this reason the
LM curve slopes upward as illustrated above.
How Monetary Policy Shifts the LM Curve
The LM curve tells us the interest rate that equilibrates the money market for any given level of
income. The theory of liquidity preference shows that the equilibrium interest rate depends on
the supply of real balances. The LM curve is drawn for a given supply of real money balances. If
real balances change, the LM curve will shift.
Suppose that the money supply is decreased from M1 to M2, which causes the supply of real
balances to fall from M1/P to M2/P. Holding constant the amount of income and thus the
demand curve for real balances, a reduction in the supply of real balances raises the interest rate
that equilibrates the money market. Hence, a decrease in real balances shifts the LM curve
upward.
A Quantity-Equation Interpretation of the LM Curve
The quantity theory of money states that MV(r) = PY; where V is velocity. A higher interest rate
raises the cost of holding money and reduces money demand. As people respond to a higher
interest rate by reducing the amount of money they hold, each currency in the economy
circulates from person to person more quickly- i.e. velocity of money increases. This implies that
r and V are positively related.
An increase in the interest rate raises the velocity of money. For a given money supply and price
level, it raises the level of income (to maintain the equality). The LM curve expresses this
positive relationship between the interest rate and income.

This equation also shows why changes in the money supply shift the LM curve. For any given
interest rate (i.e. constant velocity) and price level, an increase in the money supply raises the
level of income. Thus, increases in the money supply shift the LM curve to the right, and
decreases in the money supply shift the LM curve to the left.
Conclusion: The Short-Run Equilibrium
We now have all the components of the ISLM model. The two equations of this model are
Y= C (Y-T) + I(r) +G IS
M/P = L(r, Y). LM
The model takes fiscal policy, G and T, monetary policy M, and the price level P as exogenous.
Given these exogenous variables, the IS curve provides the combination of r and Y that satisfy
the equation representing the goods market, and the LM curve provides the combinations of r
and Y that satisfy the equation representing the money market. These two curves are shown
together in the figure below.
The equilibrium of the economy is the point at which the IS curve and the LM curve cross. This
point gives the interest rate r and the level of income Y that satisfy both the goods market
equilibrium and the money market equilibrium condition. In other words, at this intersection,
actual expenditure equals planned expenditure, and the demand for real money balances equals
the supply.
2.3. The Short Run IS-LM Model and Monetary and Fiscal Policy Analysis
The intersection of the IS curve and the LM curve determines the level of national income.
National income fluctuates when one of these curves shifts, changing the short-run equilibrium
of the economy.
Change in Fiscal Policy

Suppose that we start in equilibrium and that government spending is increased by ∆G. Then
the IS curve shifts to the right. The increased spending increases income and, through the
multiplier effects from the circular flow, also increases consumption; income increases further.

(Recall that the rightward shift of the IS curve equals ∆G/(1-MPC).) If we only had to worry
about the goods market, this would be the end of the story. But the increase in income, in turn,
increases the demand for money for transaction purposes. This increased demand for money
forces up the interest rate, leading, in turn, to a decline in investment. Thus we observe short-
run crowding out: The increase in GDP is less than the simple Keynesian cross model would
have predicted because that model omits changes in the interest rate. A decline in taxes, like an
increase in government spending, shifts the IS curve out, causing interest rates and GDP to rise.
As depicted in the above graph, if you compare the new equilibrium E’ to the initial equilibrium
E increased government spending raises both income and interest rate. The other important
comparison is between E’ and E” (the equilibrium in the goods market at unchanged interest
rates. The latter point simply corresponds to the equilibrium we studied in the Keynesian cross
model by neglecting the impact of interest rates on the economy. From the above comparison
therefore, it is clear that the adjustment of interest rates and their impact on aggregate demand
dampen the expansionary effect of increased government spending. Income instead of
increasing to level Y”, rises only to Y’0.
The reason as it is explained previously, is that the rise in the interest rate from i0 to i’ reduces the
level of investment spending. In such cases we say that the increase in government spending
crowds out investment spending.
The degree of crowding out usually depend on the shapes of the IS and LM curves which again
determines the extent of increase in interest rate following the increase in government spending.
The other issue that determine the degree of crowding out is the extent to which investment
responds to interest rates in the economy because investment in most economies (consider
Africa and more specifically Ethiopia) is not merely determined by interest rate. In addition to
that the magnitude of crowding out also depends up on: first, whether there are huge
unemployed resources in the economy or not because in those economies with unemployed
resources there will not be full crowding out (since the rise in income has also an impact on
saving and hence the expansion in saving makes it possible to finance a larger budget deficit
without displacing investment spending); second, whether there is huge unemployment or not
because if there is unemployment, there is a possibility for output to expand without a rise in
interest rate and hence there need not be any crowding out. This is true because the monetary
authorities can accommodate the fiscal expansion by an increase in the money supply. Monetary

policy is accommodating when, in the course of fiscal expansion, the money supply is increased
in order to prevent interest rates from increasing (see figure below).
Generally, the extent of crowding out is greater the more the interest rate increases when
government spending rises.
Classical and Keynesian explanation of crowding out

The classical case and crowding out
In the extreme classical case, since interest rate has full power this will lead to vertical LM curve.
If the LM curve is vertical, an increase in government spending has no effect on the equilibrium
level of income and increases only interest rate. Because in the classical case investment is
determined by interest rate, an increase in interest rate crowds out an amount of investment
spending equal to the increase in government spending (see figure below). In this case we say
there is full crowding out.
The Keynesian case and crowding out
In the extreme Keynesian case the economy is considered as if it is in liquidity trap (a situation in
which the public is prepared, at a given interest rate, to hold whatever amount of money is
supplied). This implies that the LM curve is horizontal and hence an increase in government
spending has its full multiplier effect on the equilibrium level of income. There is no change in
the interest rate associated with the change in government spending, and thus no investment
spending is cut off. There is therefore no dampening of the effects of increased government
spending on income (i.e. no crowding out). In this case therefore fiscal policy has a maximal
effect on income.

Changes in Monetary Policy

Consider the effects of an increase in the money supply. This shifts the LM curve out. The
increased money supply causes interest rates to fall in order to bring the demand for money in
line with the new higher supply. This fall in interest rates encourages investment, leading
ultimately to an increase in GDP. Thus interest rates are lower and GDP is higher. The linkage
from a change in the money supply to GDP is known as the monetary transmission
mechanism.
This shows that an increase in money supply raises the level of income. The transmission
mechanism in the context of the IS-LM model is that an increase in the money supply lowers the
interest rate, which stimulates investment and thereby expands the demand for goods and
services.

Interaction between Monetary and Fiscal Policy
When analyzing any change in monetary or fiscal policy, it is important to note that these
policies may not be independent of each other. A change in one may not be independent of each
other. A change in one may influence the other. This interdependence may alter the impact of a
policy change.
Suppose that the fiscal authorities increase taxes. Other things equal, this would reduce output
and interest rate in the short run (Case 1). If the monetary authority is trying to keep interest
rates stable, however, it would respond to this change by decreasing the money supply. The
result would be a larger decrease in output (Case 2). Alternatively, the monetary authorities
might be trying to keep output stable, in which case it would increase the money supply, driving
interest rates down further (Case 3). The basic issue is that the ultimate effects on the economy
depend upon the combinations of policies chosen by the monetary and fiscal authorities.
Aggregate Demand and the ISLM
We now consider how the ISLM model can also be viewed as a theory of aggregate demand. We
defined the IS and LM curves in terms of equilibrium in the goods and money markets,
respectively. Aggregate demand summarizes equilibrium in both of these markets. Recall that the
ISLM model is constructed on the basis of a fixed price level. For a given value of the price level
and the nominal money supply, the position of the LM curve is fixed. The real money supply
changes if either the nominal money supply or the price level changes. Thus we can see that
changes in the price level are associated with changes in the equilibrium level of output and
interest rates. This is the relationship that is summarized by the aggregate demand curve.
If the price level is high, other things equal, the real money supply is low. This implies high
interest rates, and thus low investment and output. If the price level falls, then the real money
supply increases. Equilibrium in the money market implies that interest rates must fall.
Equilibrium in the goods market thus implies that output must rise, since investment rises. Thus
we find that the aggregate demand curve is downward sloping; high values of the price level are
associated with low level of output, and vice versa. Note that the reason this curve slopes
downward is not easy to describe; it is not like the regular microeconomic demand curve for
a good.

Monetary policy, Fiscal policy and Aggregate Demand
Because the aggregate demand curve summarizes the results of the ISLM model, shocks that
shift the IS curve or the LM curve cause the aggregate demand curve to shift. Thus, the result
can be summarized as follows: A change in income in the ISLM model resulting from a change
in the price level represents a movement along the aggregate demand curve. A change in
income in the ISLM model for a fixed price level represents a shift in the aggregate demand
curve. Now let us see how expansionary monetary and expansionary fiscal policy affect the
aggregate demand curve.

(a) Expansionary Monetary Policy

and Aggregate Demand
Price level, P
Interest rate, r LM1
LM2
AD2
IS AD1
Income, output, Y
(b) Expansionary Fiscal Policy and

Aggregate Demand
Interest rate, r LM1 Price level, P
IS2
AD2
IS1 AD1
Income, output, Y Income, output, Y
The above four diagrams in (a) and (b) show how monetary and fiscal policy affect aggregate
demand in the economy. The diagram in (a) shows monetary expansion i.e an increase in the
money supply(M). For any given price level, an increase in the money supply raises real money
balances, shifts the LM curve down ward, and raises income. Hence, an increase in the money
supply shifts the aggregate demand curve to the right from AD1 to AD2.
The diagram in (b) shows a fiscal expansion such as an increase in government purchase or a
decrease in taxes. The fiscal expansion shifts the IS curve to the right and, for any given price
level, raises income. Hence, fiscal expansion shifts the aggregate demand curve to the right from
AD1 to AD2.

Conversely, a decrease in the money supply, a decrease in government purchases, or an increase

in taxes lowers income in the IS-LM model and shifts the aggregate demand curve to the left.
The ISLM Model in the Long Run
We can also analyze the transition to the long run in the ISLM model. If the economy is not at
full employment, then the price level adjusts. In terms of the AD-AS diagram, the economy
moves along the AD curve. In terms of the ISLM diagram, the LM curve shifts. Thus we can see
that the process of adjustment to equilibrium has subtle economic forces lying behind it. If, for
example, we start in recession, then over time prices fall. This increases the real money balance,
pushing down interest rates and encouraging investment. This increase in investment, in turn,
leads to higher spending and higher output.
Limitations of ISLM Model
Both the simple income-expenditure model and the quantity theory of money engage in drastic
aggregation. The quantity theory of money aggregates the economy into only two markets, the
market for money balances and the market for all other things. The simple income-expenditure
model involves an equally drastic but different aggregation, to a market for goods and services
and a market for all other things. Then each, by Walras' Law, ignores the second market and
focuses on only one market. These drastic aggregations make sense if the main source of
problems in a market economy arise in only one sector and the problems that are evident in
other sectors are simply reflections of problems that originate in that one sector. A year after the
publication of the General Theory, John Hicks proposed ISLM as a less dramatic aggregation
that he saw as a more general case of both the quantity theory and the simple income-
expenditure model. Part of its popularity this model, which has reigned as the standard
macroeconomic model for half a century, undoubtedly lies in its ability to present
macroeconomics in terms of a model with exactly the same structure and mechanics as the
model of supply and demand.

Though the ISLM model is a fundamental model of macroeconomics, seldom do

macroeconomists try to estimate the parameters of the model and use it to predict the future
course of GDP. There has been at least one attempt to estimate the importance of fiscal and
monetary policy with equations similar to the equation one attains when one solves the model
for equilibrium income. However, many economists have argued that such an approach could
not capture the subtleties of how the economy works and thus do not give reliable estimates.
The fact that economists have not used the ISLM model in their attempts to numerically
predict the effects of policy suggests that ISLM has weaknesses. The first of these is the question
of whether or not ISLM is meant as a long-run or short-run model. If it is meant as a long-run
model, then its prediction that equilibrium can exist at any level of output is controversial. ISLM
aggregates the economy into three markets: goods, money, and all other.
This aggregation makes sense if nothing interesting happens in the "all-other" market, if it
simply adjusts passively to changes in the goods and money market. Included in the passively
adjusting sector is the resource market, even though many economists point to the labor market
as a sector that does not readjust rapidly.
ISLM predicts the equilibrium can be at any level because it assumes, as does the simple income-
expenditure model, a passive supply. Sellers produce whatever is demanded, and all adjustment
to changes in demand are in the form of changes in output and none of the adjustment is in the
form of changes in prices. Adjustment cannot be in the form of price changes because the price
level does not enter the model. Since changes in prices are the primary way markets adjust in
microeconomic theory, the failure of ISLM to say anything about prices is a serious weakness. If
meant as a short-run model, the model is severely limited because it does not incorporate the
rate of inflation. Inflation creates a difference between real and nominal interest rates. The
nominal rate is the visible rate that people pay and receive, and the real interest rate is what is
happening in terms of purchasing power. Thus if the rate of interest is 5% and the rate of
inflation is 10%, a person who borrows $100 and pays back $105 in a year will pay back less in
terms of purchasing power than he borrowed. He pays back 105 dollars, but each dollar can buy
10% less than it did a year earlier. Hence his rate of interest in real terms is actually negative. The
real interest rate is computed as the nominal interest rate less the rate of inflation. The
distinction between real and nominal interest rates is important in ISLM because investment
spending should respond to the real interest rate and money demand to the nominal interest
rate. To see why investment depends on the real rate, consider a situation of zero inflation in
which a person buys a machine that will cost $100 and earn $105 one year later. This purchase
will be worthwhile if the interest rate is below 5%. Now suppose that inflation jumps from zero
to 10%. The same machine will produce the same output, but because of the increase in prices,
the output will be 10% more valuable in terms of the money it brings. Thus the $100 machine
will earn $115.05 (which is 10% more than 105) in one year.
The investment is now worthwhile at any nominal rate under 15% (which is a real rate under
5%.) Investment will remain constant if the real interest rate does not change; change in nominal
rates will not change investment if it does not change the real rate.
To keep the demand for money constant (which means that the velocity of circulation remains
constant), the nominal interest rate must remain constant. When people hold cash balances for

transactions; they are concerned with purchasing power. If all prices double, the amount of
money people want to hold will double, but the amount of purchasing power they want will
remain constant. The interest rate is a cost of holding purchasing power. If the rate of inflation
increases, and the rate of interest with it, holding money becomes more expensive and people
will want to hold smaller amounts of purchasing power. Thinking of the demand for money in
terms of purchasing power lets us ignore price level and is the key to seeing the effects of the
rate of interest. It is the nominal rate, not the real rate that matters.
Further, the rate of inflation independently affects the demand for money by changing its
desirability as a store of wealth. In cases of very serious inflation, such as the German
hyperinflation of 1923, people try to spend money as quickly as possible because it is losing its
value. As a result, the velocity of money increases. To some extent estimates of how sensitive
money demand is to interest rates may be catching this sensitivity of money demand to inflation
because rates of inflation and interest rates move together.
One could graph the ISLM model assuming that the vertical axis measured the real rate. Then
any time the rate of inflation changed (and thus the nominal rate), one could shift the LM curve.
A more rapid inflation would shift the LM curve to the right, for example, reducing real interest
rates and increasing income. The problem with this solution, however, is that it leaves the rate of
inflation as autonomous, unrelated to what is happening to fiscal and monetary policy. Though
there have been times when many economists considered inflation autonomous ("cost-push"
theories that were very popular in the 1950s are an example—prices rise because costs rise),
most economists believe that macroeconomic policy is by far the most important determinant of
rates of inflation.
Given these serious weaknesses, why has ISLM remained as a framework for so much
macroeconomic thinking? A major reason is that no other simple model gives as much insight.
ISLM suggests that economic disturbances can arise in either the money market or the goods
market, a conclusion that predates ISLM. Economists want a simple model that concludes this.
Also, ISLM can be expanded and made more complex in an effort to overcome its limitations.

2.4. Aggregate Supply Analysis
2.4.1 Introduction
Up to now an attempt was made to analyze the demand side of the economy taking the price
level p as exogenously determined. This section develops the supply side of macroeconomy.
This will give us a supply curve to add to our demand curve, so that by equating supply and
demand in the economy we obtain endogenously determined equilibrium values of output and
the price level. More focus will also be given to overview different aggregate supply models and
how the shape of the aggregate supply curve will take in different models.
Aggregate supply is the relationship between quantity of goods and services supplied and the
price level. Because the firms that supply goods and services have flexible prices in the long run
but sticky prices in the short run, the aggregate supply relationship depends on the time horizon.
Here we need to discuss two different aggregate supply curves: the long run aggregate supply
curve LRAS (the classical supply curve) and that of the short-run aggregate supply curve SRAS
(the Keynesian supply curve). Finally an attempt will be made to present four prominent models
of short-run aggregate supply curve.
The Long Run: the Vertical Aggregate Supply Curve
Because the classical model describes how the economy behaves in the long run, we derive the
long-run aggregate supply curve from the classical model. The classical aggregate supply curve is
vertical, indicating that the same amount of goods will be supplied whatever the price level i.e.
output does not depend on the price level (see figure below). The classical supply curve is based
on the assumption that the labor market is in equilibrium with full employment of the labor
force.
Long run aggregate supply, LRAS

Price level, P
Y
Income, output, Y
If the aggregate supply curve is vertical, then changes in aggregate demand affect prices but not
output. For example, if the money supply falls, the aggregate demand curve shifts downwards, as
in figure below. The economy moves from the old intersection of aggregate supply and
aggregate demand, point A to the new intersection, point B. If it is an increase in money supply,
the economy moves from A to C. The shift in aggregate demand affects only prices.

The vertical aggregate supply curve satisfies the classical dichotomy, because it implies that the
level of out put is independent of the money supply. This long run level of output is called the
full employment or natural level of output.
LRAS
Price level, P
C
A
Y
Income, output, Y
The Short Run: the Horizontal Aggregate Supply Curve and the move from the Short
Run to the Long run
It is clear from the above discussion that the classical model and the vertical aggregate supply
curve apply only in the long run. In the short run, some prices are sticky and, therefore, do not
adjust to changes in demand. Because of this price stickiness, short run aggregate supply curve is
not vertical (you can consider the issue of menu costs and aggregate demand externality that
make price sticky). This is what we call the Keynesian aggregate supply curve. In the extreme
Keynesian case aggregate supply curve is horizontal; indicating that firms will supply whatever
amount of goods is demanded at the existing price level (see figure below).
Price level, P
Short run aggregate supply, SRAS
Income, output, Y
The idea underlying the Keynesian aggregate supply curve is that because there is
unemployment, firms can obtain as much labor as they want at the current wage. Their average
costs of production therefore are assumed not to change as their output levels change. They are
accordingly willing to supply as much as is demanded at the existing price level.
The short run equilibrium of the economy is obtained at the intersection of the aggregate
demand curve and the horizontal short run aggregate supply curve. In this case changes in

aggregate demand either through fiscal policy or monetary policy do affect the level of out put in
the economy.
Suppose for instance the central bank reduces the money supply and the aggregate demand
curve shifts downward as in the following figure. In the short run, prices are sticky, so the
economy moves from point A to point B. Output and employment fall below their natural
levels, which means the economy, is in recession. Over time, in response to the low demand,
wages and prices fall. The gradual reduction in the price level moves the economy down ward
along the aggregate demand curve to pint C, which is the new long run equilibrium.
Price level, P
LRAS
A SRAS
B
Income, output, Y
2.4.2 The Four Models of Aggregate Supply
Economists usually analyze short-run fluctuations in aggregate income and the price level using
the model of aggregate demand and aggregate supply. In the previous sections we examined
aggregate demand in some detail. The IS-LM model shows how changes in monetary and fiscal
policy and shocks to the money and goods market shift the aggregate demand curve. In this
section we turn our attention to aggregate supply and develop theories that explain the position
and slope of the aggregate supply curve.
When we introduce the aggregate supply curve in section 2.4.1, we established that aggregate
supply behaves differently in the short run than in the long run. In the long run, prices are
flexible, and the aggregate supply curve is vertical. When the aggregate supply curve is vertical,
shifts in the aggregate demand curve affects the price level, but output remains unchanged. By
contrast, in the short run, prices are sticky, and the aggregate supply curve is not vertical. In this
case, shifts in the aggregate demand do cause fluctuations in output. In the last section we took
the extreme Keynesian case where aggregate supply curve is horizontal in which all prices are
fixed. Our task in this section is to refine this understanding of short-run aggregate supply.
Unfortunately, one fact that makes this task more problematic is that economists disagree about
how best to explain aggregate supply. As a result, in this section an attempt will be made to
present four prominent models of short-run aggregate supply curve. Although these models
differ in some significant details, they are also related in an important way: they share a common
theme about what makes the short-run and the long-run aggregate supply curves differ and a

common conclusion that short-run aggregate supply curve is upward sloping i.e. the final
destination is a short run aggregate supply equation of the form
Y = Y + α(p-pe), α >0
where Y is output, Y is the natural rate of output, p is the price level, and pe is the expected
price level. This equation states that output deviates from its natural rate when the price level
deviates from the expected price level. The parameter α indicates how much output responds to
unexpected changes in the price level; 1/α is the slope of the aggregate supply curve.
Each of these models tells different story about what lies behind this short-run aggregate supply
equation. In other words, each highlights a particular reason why unexpected movements in the
price level are associated with fluctuations in aggregate output.
a) The Sticky- Wage Model

To explain why the short-run aggregate supply curve is upward sloping, many economists stress
the sluggish adjustment of nominal wages. In many industries, nominal wages are set by long-
term contracts, so wages cannot adjust quickly when economic conditions change. Even in
industries where there is no such formal contract, implicit agreements between workers and
firms may limit wage changes. Wages may also depend on social norms and notions of fairness
that evolve slowly. For these reasons, many economists believe that nominal wages are sticky in
the short-run.
The sticky-wage model shows what a sticky nominal wage implies for aggregate supply. To
understand the model let us consider what happens to the amount of output produced when the
price level rises:
• When nominal wage is stuck, a rise in the price level lowers the real wage (W/P),
making labor cheaper.
• The lower real wage induces firms to hire more labor because labor demand is a
function of (W/P).
• The additional labor hired produces more output since output(Y) is a function of
employment (L).
This positive relationship between the price level and the amount of output means that the
aggregate supply curve slopes upward during the time when nominal wage cannot adjust.
To develop this story of aggregate supply more formally, assume that workers and firms bargain
over and agree on the nominal wage before they know what the price level will be when their
agreement takes effect. Here, Workers and firms have in mind a target real wage. The target
may be the real wage that equilibrates labor supply and demand. More likely, the target real wage
is higher than the equilibrium real wage due to union power and the efficient wage consideration
that we discussed in chapter one.
The workers and firms set the nominal wage W based on the target real wage ω and on their
expectation of the price level pe. The nominal wage they set is therefore,
W = ω * pe

Nominal wage= Target real wage * expected price
After the nominal wage has been set and before labor has been hired, firms learn the actual price
level p. The real wage turns out to be
W/P= ω * (pe/p)
expected− price−level
Real wage = Target real wage* actual− price−level
The above equation shows that the real wage deviates from its target if the actual price level
differs from the expected price level. When the actual price level is greater than expected, the
real wage is less than its target; when the actual price level is less than expected, the real wage is
greater than its target.
The final assumption of the sticky wage model is that employment is determined by the quantity
of labor that firms demand. We can describe the firm’s hiring decision by the following labor
demand function
L=Ld(W/P)
which states that the lower the real wage, the more labor firms hire.
Output is determined by the production function
Y=F(L)
which states that the more labor is hired, the more output is produced.
The sticky-wage model can now be analyzed by using the following graphs.
(a) Labor Demand (b) Production Function
Income, Output,Y
Real Wage (W/P) Y=F(L)
W/p1
W/p2 L=Ld(W/P)
L1 L2 Labor, L L1 L2 Labor, L
Y = Y + α (p-pe)
Price Level, P
P2
P1
Y1 Y2
Income, Output,Y
(c) Aggregate Supply

Panel (a) shows the labor demand curve. Because the nominal wage W is stuck, an increase in
the price level from p1 to p2 reduces real wage from w/p1 to W/p2. The lower real wage raises
the quantity of labor demanded from L1 to L2. Panel (b) shows the production function. An
increase in the quantity of labor from L1 to L2 raises output from Y1 to Y2. Panel (c) on the
other hand shows the aggregate supply curve that summarizes the relationship between the price
level and output. An increase in the price level from p1 to p2 raises output from Y1 to Y2.
Because the nominal wage is sticky in this model, an expected change in the price level moves
the real wage away from the target real wage, and this change in the real influences the amounts
of labor hired and output produced. The aggregate supply curve can be written as
Y = Y + α (p-pe)
The equation states that output deviates from its natural rate when the price level deviates from
the expected price level.
b) The Imperfect Information Model

The second explanation for the upward slope of the short run aggregate supply curve is called
the imperfect-information model. Unlike the sticky –wage model, this model assumes that
market clear i.e. all wages and prices are free to adjust to balance supply and demand. In this
model, the short run and long-run aggregate supply curves differ because of temporary
misperceptions about prices.
The imperfect-information model assumes that each supplier in the economy produces a single
good and consumes many goods. Because the number of goods is so large, suppliers cannot
observe all prices at all times. They monitor closely the price of what they produce but less
closely the prices of all the goods they consume. Because of imperfect information, they some
times confuse changes in the overall level of prices with changes in the relative prices. This
confusion influences decisions about how much to supply, and it leads to a positive relationship
between the price level and output in the short-run.
The model implies an aggregate supply curve that is now familiar:
Y = Y + α (p-pe)
The equation states that output deviates from its natural rate when the price level deviates from
the expected price level.
c) The Sticky-Price Model

Our third explanation for the upward sloping short-run aggregate supply curve is called the
sticky-price model. This model emphasizes that firms do not instantly adjust the prices they
charge in response to changes in demand. Sometimes prices are set by long-term contracts

between firms and customers. Even with out formal agreements, firms may hold prices steady in
order not to annoy their regular customers with frequent price changes. Some prices are sticky
because of the way markets are structured: once a firm has printed and distributed its catalog or
price list, it is costly to alter prices.
To see how sticky prices can help explain an upward sloping aggregate supply curve, we first
consider the pricing decisions of individual firms and then add together the decisions of many
firms to explain the behavior of the economy as a whole.
Consider the pricing decision facing a typical firm. The firm’s desired price P depends on two
macroeconomic variables:
• The overall level of prices P. A higher price level implies that the firm’s costs
are higher. Hence, the higher the overall price level, the more the firm would
like to charge for its product.
• The level of aggregate income Y. A higher level of income raises the demand
for the firm’s product. Because marginal cost increases at higher levels of
production, the greater the demand, the higher the firm’s desired price.
We write the firm’s desired price as

Р=P+ β (Y- Y ).
This equation says that the desired price Р depends on the overall level of prices P and on the
level of aggregate output relative to the natural rate Y- Y . The parameter α (which is greater than
zero) measures how much the firm’s desired price responds to the level of aggregate output.
Now assume that there are two types of firms. Some have flexible prices: they always set their
prices according to this equation. Others have sticky prices: they announce their prices in
advance based on what they expect economic conditions to be. Firms with sticky prices set
prices according to
Р=Pe+ β (Ye- Y e).
Where, as before, a subscript “e” represents the expected value of a variable. For simplicity,
assume that these firms expect output to be at its natural rate, so that the last term α(Ye- Y e), is
zero. Then these firms set the price
Р=Pe.
That is, firms with sticky prices set their prices based on what they expect other firms to change.
We can use the pricing rules of the two groups of firms to derive the aggregate supply equation.
To do this, we find the overall price level in the economy, which is the weighted average of the
prices set by the two groups. If s is the fraction of firms with sticky prices and 1-s the fraction
with flexible-prices, then the overall price level is
P=sPe+(1-s)[ P+ β (Y- Y )]

The first term is the price of the sticky-price firms weighted by their fraction in the economy,
and the second term is the price of the flexible price firms weighted by their fraction. Now
subtract (1-s)p from both sides of this equation to obtain
sP=sPe+(1-s)[ β (Y- Y )].
Divide both sides by s to solve for the overall price level:

P=Pe+ [(1-s) β /s](Y- Y )].
The two terms in this equation are explained as follows:
• When firms expect a high price level, they expect high costs. Those firms
that fix prices in advance set their prices high. These high prices cause the
other firms to set high prices also. Hence, a high expected price level Pe leads
to a high actual price p.
• When output is high, the demand for goods is high. Those firms with flexible
prices set their prices high, which leads to a high price level. The effect of
output on the price level depends on the proportion of firms with flexible
prices.
Hence, the overall all price level depends on the expected price level and on the level of output.
Algebraic rearrangement puts this aggregate pricing equation into a more familiar form:
Y = Y + α (p-pe).
where α = s/[1-s) β ]. Like the other models, the sticky-price model says that the deviation of
output from the natural rate is positively associated with the deviation of output from the natural
rate is positively associated with the deviation of the price level from the expected price level.
d) The Workers –misperception Model
The workers misperception model like that of the sticky wage model focuses on the labor
market. It assumes wages are not sticky, but they are free to equilibrate supply and demand in
the labor market. Its key principle is that workers temporary confuse real and nominal wages.
The components of the model are labor demand (Ld) and labor supply (Ls) where labor demand
is a function of the real wage (W/P), while labor supply is a function of the real wage that
workers expect (W/Pe). Workers know W, but they do not know the overall price P. Hence,
when they decide on how much to work, they consider the expected real wage to be
W/P=W/P*P/Pe
That implies expected real wage is the product of actual real wage and misperception of workers
regarding the level of prices. Hence, labor supply (Ls)= Ls(W/P*P/Pe ) that implies labor supply
is determined by the real wage and worker’s misperceptions.

The implication for aggregate supply
To see the implication of this model for aggregate supply consider an increase in the price level,
P and its impact on the labor market. When P rises there are two possible reactions in the model
1. If workers anticipated the change, then Pe rises proportionately with P and hence there is
no change in labor demand and labor supply.
2. But if workers are not aware of the price change, Pe remains the same. Then, at every
real wage, workers are willing to supply more labor because they believe that their real
wage is higher than it actually is. The increase in P/Pe shifts the labor supply curve
outward. The outward shift in labor supply lowers real wage and raise the level of
employment. In essence, the increase in nominal wage caused by the rise in price level
leads workers to think that their real wage is higher, which induces them to supply more
labor. But in actuality, the nominal wage rise by less than the price level. Here, firms are
assumed to be better informed than workers and to recognize the fall in the real wage, so
they higher more labor and produce more output.
In general, this model says that deviation of prices from Pe induce workers to alter their
supply of labor.
Conclusion
In this part we have seen different models of aggregate supply and the market imperfection that
each uses to explain why the short run aggregate supply curve is upward sloping. Although all
models of aggregate supply differ in their assumptions and emphasis, their implications for
aggregate output are similar. All can be summarized by the equation
+ α (p-pe).
Y = Y
Short run equilibrium in the economy can now be explained by combining aggregate demand
and aggregate supply as follows

In the short run, the equilibrium moves from point A to B. the increase in aggregate demand
raises the actual price level from P1 to P2. Because people did not expect this increase in the
price level, the expected price level remains at Pe2, and output rises from Y1 to Y2, which is
above the natural rate Y. Thus, the unexpected expansion in aggregate demand causes the
economy to boom.
Yet the boom does not last forever. In the long run, the expected price level rises to catch up
with reality, causing the SR aggregate supply curve to shift upward. As the expected price level
rises from Pe2 to Pe3, the equilibrium of the economy moves from point B to point C. The
actual price level rises from P2 to P3, and output falls from Y2 to Y3 = Y . In other words, the
economy returns to the natural level of output in the long run, but at a much higher price level.
Diagrammatic Summary of the theory of short-run fluctuations
References:
Branson, W. (2002) Macroeconomics theory and Practice, AITBS publishers, New Delhi
Delhi
Mankew, G.(2003). Macroeconomics, 5th ed., worth publishing, New York

Chapter-III
Introduction to Open Economy Macroeconomics
Introduction
The last three decades have seen an increased international interdependence, as controls on
capital flows between countries have been much reduced. Also, since the early 1970s, so many
countries have permitted much more flexibility in their exchange rates. These developments
have raised several issues: how does the exchange rate regime affect the efficacy of domestic
monetary and fiscal policies undertaken by small, open economies? Why have exchange rates
been so volatile, and why do they appear to diverge, for significant period of time, from the
fundamental determinant of exchange rates (differences in inflation rates across countries)? Can
expansionary policies in one group of countries lead to contractionary impacts on their trading
partners? In response to such kind of questions many analysts have contributed to the rapid
development of open-economy macro models. The purpose of this chapter is to survey some of
these developments.
We shall start in this chapter by explaining some basic macro economic concepts and the basics
of open economy model. Finally, an attempt will be made to analyze the standard Mundell-
Fleming model which is an open economy version of the IS-LM model we discussed in the last
chapter.
3.1 Basic Concepts in Open Economy Macroeconomics
A. Exchange Rate
This is perhaps the central concept in an open economy. The exchange rate (E) is the rate at
which one currency exchanges for another. It is, therefore, a monetary phenomenon. One may
view the exchange rate as indicative of the relative price of goods and services denominated in
the currencies of the two countries concerned. Alternatively, the exchange rate can be regarded
as the relative price of assets denominated in the currencies of a pair of countries. In any case,
conversion from one currency unit to another is the job of the exchange rate. There are two
conventions for measuring the exchange rate, the distinction between which can be the source
of serious confusion:
1. Domestic currency units per unit of foreign currency
For example, if the birr is the home currency and the dollar ( $) is the foreign Currency, and
1birr exchanges for $2, then the exchange rat is 0.5 or ½. The domestic currency is on the
numerator of the ratio. Note that this definition means that whenever E rises the home currency
gets weaker; it depreciates. For example, arise from 0.5 to 0.67 means that 1 birr exchanged for
$1.5, less than before. Conversely, when E falls, the domestic currency gets stronger, it appreciates.
2. Foreign currency units per unit of domestic currency

This is exactly the converse of the first convention. The domestic currency is on the
denominator. When 1birr is exchanged for $2, the exchange rate is 2 if E rises, the home
currency gets stronger, and vice versa.
3. Real vs. Nominal Exchange Rates
The real exchange rate is the ratio of foreign to domestic prices, measured in the same currency.
It measures a country’s competitiveness in the international trade.
The real exchange rate R, is usually defined as
R=ePf/P
Where P and Pf are the price levels here and abroad, respectively and e is the birr price of
foreign exchange (the nominal exchange rate). If the exchange rate equals 1, currencies are at
purchasing power parity (PPP). A real exchange rate above 1 means, that goods abroad are more
expensive than goods at home. Other things equal, this implies that people- both at home and
abroad- are likely to switch some of their spending to goods produced at home. This is often
described as an increase in the competitiveness of our products. As long as R is greater than 1,
we expect the relative demand for domestically produced goods to rise.
Nominal Exchange rate (e) is the relative price of currency of two countries. For example, if the
exchange rate between the Ethiopian birr and the U.S dollar is 8 birr per dollar, then you can
exchange one dollar for 8 birr in the world markets for foreign currency.
4. Fixed versus Flexible Exchange rates
First, there are flexible exchange rates. Under this system the exchange rate is completely
market- determined, without any interference from government authorities (the center bank).
The balance of payments balances: surpluses are eliminated via exchange rates appreciation;
deficits are cured by exchange rate depreciation. In other words, balance of payments
disequilibria are self correcting. Secondly, there are fixed exchange rates. Here the rate of
exchange is a policy parameter fixed by the authorities. They have to meet excess demand for a
foreign currency (not financed by sales in that foreign country) from their reserves of foreign
currency. Net inflows of foreign currency swell the domestic money supply, as private economic
agents who do note use it to purchase goods abroad convert foreign currency to domestic
money at the fixed rate of exchange. Fixed exchange rates make the domestic money Supply
dependent on changes in foreign exchange reserves. Also, balance of payments deficits cause
reserve losses and surpluses cause reserve to be built up: there is no self- correcting mechanism
to balance of payments disequilibria. These two exchange rate regimes are the two polar
extremes in the economics of exchange rate. In reality we have a pastiche of arrangement,
somewhere in between the two. Even with flexible rates, central banks do interfere with the
market- determined exchange rate, often in an internationally concerted fashion. This is known
as a managed float (consider the Ethiopian case). Fixed Exchange rates also allow for
realignments and changes in the exchange rate, usually devaluation.
5. Devaluation versus Revaluation.
Exchange rate language can be very confusing. In particular, the terms depreciation,
appreciation, devaluation and revaluation (overvaluation) recur in any discussion of open

economy macroeconomics. Here we will try to define such terminologies here so that we can
able to facilitate our upcoming discussions.
Devaluation takes place when the price of foreign currencies under fixed exchange rate regime is
increased by official action (you can consider the action of the Ethiopian government to devalue
the currency in 1992. The Birr was devalued in 1992 and this is expected to promote exporters
and discourage importers. This will narrow the gap between exports and imports and
consequently improve the current account. It also narrows the gap between the official and
parallel or black market rates and abolishes illegal trade in the country.)
Devaluation thus means that foreigners pay less for devalued currency and that residents of the
devaluing country pay more for foreign currencies. The opposite of devaluation is revaluation.
6. Depreciation versus Appreciations
A currency is said to be depreciate when under floating rates it becomes less expensive in terms
of foreign currency. By contrast currency appreciates when it becomes more expensive in terms
of foreign money.
B. Current Account and Capital Account
By capital account we refer to the transactions into domestic currency (capital inflows) and into
foreign currency (capital outflows). These movements of funds are motivated by asset market
consideration; money flows in to the domestic financial market if domestic money and financial
assets are more attractive relative to foreign currency assets. This relative attractiveness is usually
measured by the differential between domestic and foreign interest rates, funds flowing into the
country with the higher returns. The capital account records purchases and sales of assets, such
as stocks, bonds, and land.
Current account on the other hand is the account that records trade in goods and service, as well
as transfer payments.
The balance of payment is therefore composed of these two accounts.
3.2 The Basic Open Economy Model

3.2.1. Open Economy National Income Identity
The key macroeconomic difference between open and closed economies is that, in an open
economy, a country’s spending in any given year need not equal its output of goods and services.
A country can spend more than it produces by borrowing from abroad, or it can spend less than
it produces and lend the difference to foreigners.
In an open economy gross domestic product (GDP) differs from that of a closed economy
because there is an additional injection- export expenditure which represents foreign expenditure
on domestically produced goods. There is also an additional leakage, expenditure on imports
which represents domestic expenditure on foreign goods and which raises foreign national
income. The identity for an open economy is given by:

Y = C + I + G + X – M------------------------------------- (1)
where Y is national income, C is domestic consumption, I is domestic investment, G is

government expenditure, X is export expenditure and M is import expenditure. If we deduct
taxation from the right-hand side of equation [3.1] we have:
Yd = C + I + G + X – M –T------------------------------- (2)
where Yd is disposable income.

If we denote private savings as S = Yd – C we can rearrange equation [2] to obtain:
(X – M) = (S – I) + (T – G) -- (3)
Current account balance Net (dis)saving of private sector Government fiscal deficit/ surplus
Equation [3] says that a current account deficit has a counterpart in either private dis-saving-that
is private investment exceeding private saving- and/or in a government deficit- that, government
expenditure exceeding government taxation revenue. The equation is merely an identity and says
nothing about causation. Nonetheless, it is often stated that the current account deficit is due to
lack of private savings and/or the government budget deficit.
However, it is possible that the causation runs the other way, with the current account deficit
being responsible for the lack of private savings or budget deficit.
3.2.2. Income determination in an open economy
In an open economy, the equilibrium level of national income is determined where the domestic
balance is equals to the external balance. The starting point would be equation [1]
Y = C + I + G + X – M; and we would make certain additions to this equation.
Domestic consumption is partly autonomous and partly determined by the level of national
income. This is denoted algebraically by:
C =Ca + cY------------ (4)
where Ca is autonomous consumption and c is the marginal propensity to consume, that is the
fraction of any increase in income that is spent on consumption. In this simple model
consumption is assumed to be a linear function of income. An increase in consumers’ income
induces an increase in their consumption.
Import expenditure is also assumed to be partly autonomous and partly a positive function of
the level of domestic income:
M = Ma + mY---------------(5)
where Ma is autonomous import expenditure and m is the marginal propensity to import, that is
the fraction of any increase in income that is spent on imports. In this simple formulation
import expenditure is assumed to be a positive linear function of income. There are several
justifications for this; on the one hand increased income leads to increased expenditure on

imports, and also more domestic production normally requires more imports of intermediate
goods.
Government expenditure and exports are assumed to be exogenous; government expenditure

being determined independently by political decisions, and exports by foreign expenditure
decisions and foreign income.
Substituting equations [4] and [5] into equation [1] we obtain:
Y = Ca + cY + I + G + X - Ma + mY-------------------- (6)
Rearranging [6], we have
Y - Ca + cY + I + G = X - Ma + mY
Y – AD(Y) = NX(Y) ---------------------------------------- (7)
where AD is aggregate demand which is equals to Ca + cY + I + G and NX is net export

defined as X - Ma + mY.
Equation [7] tells us that the economy would be in equilibrium where the domestic balance – i.e.
Y – AD is equals to the external balance – i.e. NX. Income (Y) and net export balance
associated with this condition are the equilibrium levels of output and trade balance. The
equilibrium condition stated in equation [3.7] is depicted on the figure below.

3.2.3. Open-Economy Multipliers
John Maynard Keynes in his classic work The General Theory of Employment, Interest and
Money(1936) pioneered the use of multiplier analysis to examine the effects of changes in
government expenditure and investment on output and employment. However, his work was
concerned almost exclusively with a closed economy. It was not long, however, before the ideas
of Keynes' work were applied to an analysis of open economies, most notably by Fritz Machlup
(1943).
The assumptions underlying basic multiplier analysis are:
both domestic prices and the exchanger rate are fixed,

The economy is operating at less than full employment so that increases in demand
result in an expansion of output, and
The authorities adjust the money supply to changes in money demand by pegging the
domestic interest rate.
The implication of the last assumption is that increases in output that lead to a rise in money
demand would, with a fixed money supply, lead to a rise in the domestic interest rate. But it is
assumed that the authorities passively expand the money stock to meet any increase in money
demand so that interest rates do not have to change. There is no inflation resulting from the
money supply expansion because it is merely a response to the increase in money demand.
Rearranging equation [6]

Y = Ca + cY + I + G + X - Ma + mY
(1- c + m)Y = Ca + I + G + X – Ma----------------------------------- (8)
Given that (1- c) is equal to the marginal propensity to save s, that is, the fraction of any increase
in income that is saved, then we obtain:
------------------ (9)
Equation {9] can be transformed into difference form to yield:
----- (10)
(a) The Government Expenditure Multiplier
The first multiplier of interest is the government expenditure multiplier, which shows the
increase in national income resulting from a given increase in government expenditure. This is
given by:

The above equation says that an increase in government expenditure will have an expansionary
effect on national income, the size of which depends upon the marginal propensity to save and
the marginal propensity to import. Since the sum of these is less than unity, an increase in
government expenditure will result in an even greater increase in national income.
Furthermore, the value of the open-economy multiplier is less than the closed-economy
multiplier which is given by 1/s. The reason for this is that increased expenditure is spent on
both domestic and foreign goods rather than domestic goods alone, and the expenditure on
foreign goods raises foreign rather than domestic income.
(b) Export Multiplier
In this simple model, the multiplier effect of an increase in exports is identical to that of an
increase in government expenditure and is given by
In practice it is often the case that government expenditure tends to be somewhat more biased
to domestic output than private consumption expenditure, implying that the value of m is
smaller in the case of the government expenditure multiplier than in the case of the export
multiplier. If this is the case, an increase in government expenditure will have a more
expansionary effect on domestic output than an equivalent increase in exports.
(C) The Current Account Multiplier
The other relationships of interest are the effects of an increase in government expenditure
and of exports on the current account balance. The current account (CA) is given by
CA = X – Ma – mY----------------------------------- (11)
Totally differentiating [11]
d(CA) = dX – dMa – mdY
Substituting equation [10] for dY
From equation above] we can derive the effects of an increase in government expenditure on the
current account balance which is given by
That is, an increase in government spending leads to a deterioration of the current account
balance which is some fraction of the initial increase in government expenditure. This is because
economic agents spend part of the increase in income on imports.
The other multiplier of interest is the effect of an increase in exports on the current account
balance. This is given by the expression

Since s/s+m is less than unity, an increase in exports leads to an improvement in the current
account balance that is less than the original increase in exports. The explanation for this is that
part of the increase in income resulting from the additional exports is offset to some extent by
increased expenditure on imports.
3.2.4 The Problem of Internal and External Balance
During the period 1948 – 1973, the international monetary system was one of fixed exchange
rates, with the major currencies being pegged to the US dollar. Only in cases of fundamental
disequilibrium were authorities allowed to devalue or revalue their currency. This meant that
there was considerable interest in the relative effectiveness of fiscal and monetary policies as a
means of influencing the economy. Although economic policy-makers generally have many
macroeconomic objectives, the discussion in the 1950s and 1960s was primarily concerned with
two objectives. The principal goal was one of achieving full employment for the labor force
along with a stable level of prices which may be termed internal balance. Although governments
were generally committed to achieving full employment, it is widely recognized that expanding
output in an open economy will have implications for the current account. For instance,
expanding output and employment through expansionary fiscal policy will result in greater
expenditure on imports and consequently will lead to a deterioration of the current account. As
authorities had agreed to maintain fixed exchange rates, they were interested in running
equilibrium in the balance of payments. This later objective can be termed external balance.
Figure 3.2 shows the above problem of maintaining both internal and external balance
simultaneously. As a result of expansionary fiscal policy the [Y – AD(Y)] curve shifts from [Y–
D(Y)]1 to [Y – AD(Y)]2 and the new equilibrium point is achieved with a higher level of output
(Y**) but the current account balance has deteriorated simultaneously. The multipliers also tell
us the same thing- i.e.

A major lesson of this simple model is that the use of one instrument to achieve two targets –
internal and external balance- is most unlikely to be successful. The idea that a country generally
requires as many instruments as it has target was elaborated by the Nobel Prize winning
economist Jan Tinbergen (1952), and is popularly known as Tinbergen's instruments targets rule.
To maintain the external balance, devaluation would be a good candidate. By making imports
expensive in the domestic market and by making exports cheaper in the foreign market,
devaluation can improve the current account balance and hence the country can maintain its
external balance. As the figure below shows, devaluation shifts the NX curve upward from NXs
to NXs and equilibrium can be maintained at a higher level of output and better level of current
account balance.
However, the effectiveness of devaluation in yielding the above solution depends on the
Marshall-Lerner condition (MLC). The MLC can be derived as follows.
The current account balance (CA) when expressed in terms of the domestic currency is given
by:
CA = X – eM; ------------------- (12)
where e is the nominal exchange rate.
Totally differentiating [12]
d(CA)= dX – edM – Mde
Dividing by de throughout gives us
--------(13)

At this point we introduce two definitions; the price elasticity of demand for exports ŋx is
defined as the percentage change in exports over the percentage change in price as represented
by the percentage change in the exchange rate; this gives:
-------(14)
And the price elasticity of demand for imports çm is defined as the percentage change in imports
over the percentage change in their price as represented by the percentage change in the xchange
rate:
----------(15)
Substituting [14] and [15] into [13] we obtain
--------(16)
Dividing [16] by 1/M throughout we get
-------(17)
Assuming that we initially have balanced trade X = eM and hence X/eM = 1, and rearranging
[17] yields:
------(18)
Equation [18] is known as the Marshall-Lerner condition and says that starting from a position
of equilibrium in the current account, a devaluation will improve the current account; that
is, , only if the sum of the foreign elasticity of demand for exports and the home
country elasticity of demand for imports is greater than unity, that is If the
sum of these two elasticities is less than unity then a devaluation will lead to a deterioration of
the current account.
Empirical Evidence on ŋx and ŋm
The possibility that devaluation may lead to a worsening rather than improvement in the balance
of payment led to much research into empirical estimates of the elasticity of demand for exports
and imports. Economists divided up into two camps popularly known as 'elasticity optimists'

who believed that the sum of these two elasticities tended to exceed unity, and 'elasticity
pessimists' who believed that these elasticities tended to be less than unity. It was argued that
devaluation may work better for industrialized countries than for developing countries. Many
developing countries are heavily dependent upon imports so that their price elasticity of demand
for imports is likely to be very low. While for industrialized countries that have to face
competitive export markets, the price elasticity of demand for their export may be quite elastic.
The implication of the Marshall-Lerner condition is that devaluation may be a cure for some
countries balance of payment deficits but not for others.
Even for countries that devaluation is a solution for the BOP deficit, the initial J-curve effect
(see figure 3.4) may not be precluded. The J-curve shows that the deficit may initially rise but
after a lag of some time the trend would be reversed so that the BOP would be in surplus. The
J-curve effect arises mainly as elasticities are lower in the short run than in the long run, in which
case the Marshall-Lerner condition may only hold in the medium to long run.
The possibility that in the short run the Marshall-Lerner condition may not be fulfilled although
it generally holds over the longer run leads to the phenomenon of what is popularly knows as
the J-curve effect. The idea underlying the J-curve effect is that in the short run export volumes
and import volumes do not change much, so that devaluation leads to deterioration in the
current account. However, after a time lag export volumes start to increase and import volumes
start to decline; consequently the current deficit starts to improve and eventually moves into
surplus. The issue then is whether the initial deterioration in the current account is greater than
the future improvement so that overall devaluation can be said to work.
There have been numerous reasons advanced to explain the slow responsiveness of export and
import volumes in the short run and why the response is far greater in the longer run; two of the
most important are:
A time lag in consumer responses- It takes time for consumers in both the devaluing
country and the rest of the world to respond to the changed competitive situation.
A time lag in producer response- Even though devaluation improves the competitive
position of exports it will take time for domestic producers to expand production of
exportables.

3.3 The Mundell-Fleming Model
This model owes its origins to papers published by James Flemming (1962) and Robert Mundell
(1962, 1963). Their major contribution was to incorporate international capital movements into
formal macroeconomic models based on the Keynesian ISLM framework. Their papers led to
some dramatic implications concerning the effectiveness of fiscal and monetary policy for the
attainment of internal and external balance.
Derivation of the IS, LM and BP curves
Both the IS and LM curves have their usual shape. At this point our emphasis would be in
deriving the BP curve.
The balance of payments schedule shows different combinations of rates of interest and income
that are compatible with equilibrium in the balance of payments.
The overall balance of payment is made up of three major components: the current account
balance (CA), the capital account (K) and the change in the authorities' reserve (dR). By
maintaining balance in supply and demand for the currency- that is external balance- we mean
that there is no need for the authorities to have to change their holdings of foreign exchange
reserves. This implies that if there is a current account deficit there needs to be an offsetting
surplus in the capital account so that the authorities do not have to change their reserve.
Conversely, if there is a current account surplus there needs to be an offsetting deficit in the
capital account to have equilibrium in the balance of payment.
Since exports are determined exogenously and imports are a positive function of income, the
higher the level of national income the smaller will be any current account surplus of the larger
any current account deficit. The net capital flow (K) is a positive function of the domestic
interest rate. Assuming that the rate of interest in the rest of the world (rf) is fixed, the higher the
domestic interest rate (r) the greater the capital inflow into the country or the smaller any capital
outflow. This relationship is expressed as:
K = K(r – rf)
Since the balance of payment schedule shows various combinations of levels of income and the
rate of interest for which the balance of payments is in equilibrium, then
X–M+K=0

Quadrant [1] shows the relationship between the current account and level of national income.
The current balance schedule slopes downwards from left to right because increases in income
lead to a deterioration of the current account. At income level Y1 there is a current account
surplus of CA1, whereas at income level Y2 there is a CA deficit of CA2. The current account
surplus or deficit is transferred to quadrant [2] where the 450 line converts the CA position to an
equal capital flow of the opposite sign. With a CA surplus CA1 there is a required capital
outflow K1 to ensure balance of payment equilibrium; while a CA deficit CA2 requires a capital
inflow K2. Quadrant [3] shows the rate of interest that is required for a given capital flow. The
capital flow schedule is downward sloping from left to right; this is because high interest rates
encourage a net capital inflow whereas low interest rates encourage a net capital outflow. To get
a capital outflow of K1 requires the interest rate to be r1, while a capital inflow of K2 requires a
higher interest rate r2.
Since income level Y1 is associated with a balance of payment surplus, there has to be an
offsetting capital outflow K1 which requires an interest rate r1; these coordinates give a point on
the BP schedule that is depicted in quadrant [4]. The BP schedule is upward sloping because
higher levels of income cause deterioration in the current account; this necessitates a reduced
capital outflow/ higher capital inflow requiring a higher interest rate. Every point on the BP
schedule shows a combination of domestic income and rate of interest for which the overall
balance of payments is in equilibrium.
The slope of the BP schedule is determined by the degree of capital mobility internationally.
The higher the degree of capital mobility then the flatter the BP schedule would be. This is

because for a given increase in income which leads to a deterioration of the current account, the
higher the degree of capital mobility, the smaller the required rise in the domestic interest rate to
attract sufficient capital inflows to ensure overall equilibrium. When capital is perfectly mobile,
the slightest rise in the domestic interest above the world interest rate leads to a massive capital
inflow making the BP schedule horizontal at the world interest rate. At the other extreme, if
capital is perfectly immobile internationally then a rise in the domestic interest rate will fail to
attract capital inflows making the BP schedule vertical at the income level that ensures current
account balance. Between these two extremes, that is, when we have an upward sloping BP
schedule, we say that capital is imperfectly mobile.
Mathematically, the basic Mundel -Fleming model can be summarized as follows:
Monetary and Fiscal Policy Analysis in an open Economy with Different Exchange Rate
Regimes
The Mundell -Fleming Model with Perfect Capital Mobility
The model assumes a small country facing perfect capital mobility. Any attempt to raise the
domestic interest rate leads to a massive capital inflow until the interest rate return to the world
interest rate. Conversely, any attempt to lower the domestic interest rate leads to a massive
capital outflow as international investors seek higher world interest rates. The implication of

perfect capital mobility is that the BP schedule for a small open economy becomes horizontal
straight line at a domestic interest rate that is the same as the world interest rate.
(a) Small open economy with fixed exchange rate
The above figure depicts a small open economy with a fixed exchange rate. The initial level of
income is where the ISLMBP curves interest at the income level Y1. If the authorities attempt to
raise output by a monetary expansion, the LM curve shifts right from LMo to LM1; there is
downward pressure on the domestic interest rate and this results in a massive capital outflow.
This capital outflow means that there is pressure for a devaluation of the currency (as shown in
the above figure), and the authorities have to intervene in the foreign exchange market to
purchase the home currency with reserves. Such purchases result in a reduction of the money
supply in the hands of private agents, and the purchases have to continue until the LM curve
shifts back to its original position at LM0 where the domestic interest rate is restored to the
world interest rate. Hence, with perfect capital mobility and fixed exchange rates, monetary
policy is ineffective at influencing output.

Fiscal expansion shifts the IS schedule to the right from ISo to IS1. This puts upward pressure
on the domestic interest rate and leads to a capital inflow. To prevent an appreciation the
authorities have to purchase the foreign currency with domestic currency. This means that the
amount of domestic currency held by private agents increases and the LM0 schedule shifts to the
right. The increase in the money stock continues until the LM curve passes through the IS1
curve at the initial interest rate. Hence, under fixed exchange rates and perfect capital mobility an
active fiscal policy alone has the ability to achieve both internal and external balance. This is an
exception to the instruments-targets rule, although monetary policy does have to passively adjust
to maintain the fixed exchange rate.
(b) Small open economy with floating exchange rate
The initial equilibrium is at the income level Y1 where the ISo intersects the LMo. A monetary
expansion shifts the LM curve from LMo to LM1 leading to downward pressure on the interest

rate, a capital outflow, and a depreciation of the exchange rate. The depreciation leads to an
increase in exports and reduction in imports so shifting the IS curve to the right and the LM
curve to the left, so that final equilibrium is obtained at a higher level of income. Clearly with an
appropriate initial monetary expansion the authorities could obtain both internal and external
balance by monetary policy alone.
Central idea of Keynesian economics is that in the short run equilibrium economy might settle at
a level of output which is below the full employment. Government policy intervention is then
believed to be instrumental in moving the economy out of recession, via increased government
spending. Let us examine the effects of increased government spending on the economy’s
equilibrium under the assumption of fully flexible exchange rates and perfect capital mobility
whether the Keynesian presumption works for open economy.
The increase in government expenditure shifts the IS schedule to the right from ISo to IS1
leading to upward pressure on the domestic interest rate resulting in a massive capital inflow and
an appreciation of the exchange rate. The appreciation of the exchange rate results in a reduction
of exports and an increase in imports, and this forces the IS schedule back to its original
position. Hence, with perfect capital mobility and a floating exchange rate, fiscal policy is
ineffective in influencing output.
Conclusion
The result that fiscal policy is very effective at influencing output under fixed exchange rates and
monetary policy is very effective under floating exchange rates with perfect capital mobility is of
considerable relevance to economic policy design. Under fixed rates policy makers will pay more
attention to fiscal policy than under floating rates when more emphasis will be placed on
monetary policy. The degree of capital mobility and the exchange rate regime both demonstrate
that appropriate economic policy design in an open economy is very different from that in a
closed economy context.
Limitations of the Mundell-Fleming Model

1. The Marshall Lerner condition: the model assumes that the Marshall Lerner condition
holds even though it is essentially of a short term model which is the time scale under which the
Marshall-Lerner conditions are least likely to be met.
2. Interaction of stocks and flows: the model ignores the problem of the interaction of stocks
and flows. According to it a current account deficit can be financed by a capital inflow. While
such a policy is feasible in the short run, a capital inflow over time increases the stock of foreign
liabilities owed by the country to the rest of the world, and this factor means a worsening of the
future current account as interest is paid abroad. Clearly, a country cannot go on financing a
current account deficit indefinitely as the country becomes an ever-increasing debtor to the rest
of the world.
3. Neglect of the long run budget constraints: the model fails to take account of long run
constraints that govern both the private and public sector. In the long run private sector
spending has to equal its disposable income, while in the absence of money creation government
expenditure has to equal its revenue from taxation. This means that in the long run the current
account has to be in balance. One implication of these budget constraints is that a forward
looking private sector would realize that increased government expenditure will imply higher
taxation for them in the future, and this will induce increased private sector savings today that
will undermine the effectiveness of fiscal policy.
4. Wealth Effect: the model does not allow for wealth effects that may help in the process of
restoring long run equilibrium. A decrease in wealth resulting from a fall in foreign assets
associated with a current account deficit will ordinarily lead t a reduction in import expenditure
which should help to reduce the current account deficit. While such an omission of wealth
effects on the import expenditure function may be justified as being small significance in the
short run, the omission nevertheless again emphasizes the essentially short-term nature of the
model.
5. Neglect of supply side factors: one of the obvious limitations of the model is that it
concentrates on the demand side of the economy and neglects the supply side. There is an
implicit assumption that supply adjust in accordance with changes in demand. In addition,
because the aggregate supply curve is horizontal up to full employment, increases in aggregate
demand do not lead to changes in the domestic price level, rather they are reflected solely by
increases in real output.
6. Treatment of capital flows: one of the biggest problems of the model concerns the
modelling of capital flows. It is assumed that a rise in the domestic interest rate leads to a
continuous capital inflow from abroad. However, to expect such flows to continue indefinitely is
unrealistic because after a point international investors will have rearranged the stocks of their
international portfolios to their desired content and once this happens the net capital inflows
into the country will cease. The only way that the country could then continue to attract capital
inflows would be a further rise in its interest rate until once again international portfolios are
restored to their desired content. Hence a country that needs a continuous capital inflow to
finance its current account deficit has to continuously raise its interest rate. In other words,
capital inflows are a function of the change in the interest differential rather than the differential
itself.

7. Exchange rate expectations: A major problem with the model is the treatment of exchange
rate expectations. The model does not explicitly model these and implicitly presumes that the
expected change is zero, which is known as static exchange rate expectation. While this might
not seem to be an unreasonable assumption under fixed exchange rates, it is less tenable under
floating exchange rates. According to the model a monetary expansion leads to a depreciation of
the currency under floating exchange rates- in such circumstances it seems unreasonable to
assume that economic agents do not expect depreciation as well. If agents expect depreciation
this may require a rise in the domestic interest rate to encourage them to continue to hold the
currency which will have an adverse effect on domestic investment- implying a weaker
expansionary effect of monetary policy than is suggested by the model. Indeed, the need to
maintain market confidence in exchange rates can severely restrict the ability of government to
pursue expansionary fiscal and monetary policies.
References:
Delhi
Murshed, M.(1997). Macroeconomics for Open Economies, the Dryden press, London

Chapter-IV
Macroeconomic Theories and African Economies: An overview

4.1 The Applicability of Conventional Theories to African Economies
4.1.1 Introduction
Over the past decade there has appeared a serious and growing concern for the problems and
potentials of short-term macroeconomic policy in less developed countries (LDCs). There were
also much more debate on the applicability of conventional macro model to African economies
in particular and developing countries in general. But the major views can be categorized into
two:
a) The Orthodox View
According to this view such macro models are applicable elsewhere be it developed or
developing countries. For this view, the major factors responsible for low economic
development is misallocation of resources emanates from government intervention in the form
of price controls, rationing, giving priority to some sectors in the economy through subsidy.
Generally, the intervention of government makes market weak in doing its job. The solution
forwarded by this view is that to let the market to allocate resources and limit government
intervention. The guiding principle of economic decision is “price and market system is right”.
b) The Structuralist View
The structuralist view can be classified as:
Early View: it argues that the structure of developing countries is different from that of
developed countries. Developing countries have agricultural exports which are price and
income inelastic in the international market while their imports are income and price
elastic. As a result the terms of trade continue to deteriorate and therefore to achieve
long term growth government intervention is essential to help them developed their
industries. This school is the proponent of infant industry argument which focuses on
protecting the industries and on import substitution strategy.
The Recent View: this view focuses on short term adjustments. For this school
monetary and fiscal policy prescriptions that may be applicable to developed countries
are not relevant for developing countries. The IMF and the World Bank’s and
multilateral institutions have undesirable result on these economies and hence they are
against them. For instance, for short term adjustment problem (like inflation), to lower
the money supply is one of the IMF prescription. But for this recent structuralist school,
this does not have any mechanism to solve such macroeconomic problem. For
developing counties where production is predominantly agrarian, markets are
fragmented and underdeveloped; labor productivity is abysmally low, inflation is not a
demand side phenomenon. Removing structural rigidities, creating well functioning and

integrated markets to eliminate supply side rigidities should therefore be in the priorities
of development strategies.
4.1.2 Characteristics of Developing Countries
To see whether conventional theories are applicable for developing countries or not, it is
better first to review the main features of these countries. Therefore, this section is devoted
to outline these special features so that it is possible to see the structural characteristics that
differentiate a representative developing economy from the industrial-country model. These
characteristics include the nature of openness to trade with the rest of the world in both
commodities and assets, the properties of the economy’s long-run and short-run supply
functions, the nature of financial markets, the characteristics of the government’s budget and
their implication for fiscal policy, etc.
Developing countries tend to be more open and have little control over the prices of the
goods they export and import. Hence the conventional closed economy model is not
applicable.
In contrast to the major industrial countries, the vast majority of developing countries
have not adopted flexible exchange rates. They follow officially determined rates,
adjusted by a variety of alternative rules (loosely referred to as “managed” rates),
predominate. The prevalence of official parities implies that issues relating to the
macroeconomic consequences of pegging, and of rules for moving the peg are of
particular importance in developing countries.
Developing countries tend to be capital importers, and the servicing of external debt is a
central policy issue in many of them.
The extent of external trade in assets tends to be more limited in developing countries
than in industrial ones. Perfect capital mobility has become the norm for industrial
countries while capital controls are the rule in most of developing countries.
With regard to the characteristics of the government budget, aspects of the budget and
thus fiscal policy differ markedly between industrial and developing countries. In many
developing countries the state plays a pervasive role in the economy. This role is
exercised through the activities of not just the non financial public sector, but also of
financial institutions owned by the government.
With regard to the aggregate supply function, developing countries have a slightly flat
due to nominal wage rigidity accompanied by an excess supply of labor and idle capacity
that suggests that there are no significant diminishing returns. But for developed
countries it is close to full employment with less nominal wage rigidity.
The aggregate demand curve is down ward sloping just like developed countries but
much steeper. There are two reasons for this. First, the IS curve, which shifts to the left
in the standard developed countries model when the domestic price level rises because
of the effect on net exports, does not shift in the standard developing countries. Second,
the IS curve is relatively, steep due to a high marginal propensity to import and low
interest rate elasticity of investment demand.
Now in view of the above characteristics let us have a comparative static analysis on the new
wave of short-run stabilization models of LDCs, particularly African countries forwarded by
IMF which consist of devaluation and both monetary and fiscal restraint. In addition we

consider an income policy that alters the nominal wage rate. In the analysis, we contrast the
standard developed countries and developing countries models; they differ not only because the
slopes of the aggregate supply and demand curves are likely to be different, but also, and more
importantly, because the supply and demand side of the economy interact.
Richard Porter and Susan Ranny (1982) in their seminal work attempt to develop a standard least
developed country(LDC) model of aggregate demand and aggregate supply that can be readily
compared with the standard most developed country(MDC) model and conducted a
comparative static analysis on the conventional theories. Therefore, forthcoming discussion
owes much to their work.
4.1.3 Devaluation and Developing Countries
The difference between the MDC and LDC models are perhaps most evident when considering
devaluation. In the MDC, devaluation improves the balance of trade shifting the IS and the
aggregate demand curves (YD) to the right, resulting in an increase in both output and the price
level; restrictive monetary and fiscal policy are likely to be the appropriate stabilization policies
to accompany devaluation.
Fig. 4.1 Devaluation
In the LDC the analysis is more complex. For a given price level, devaluation shifts both the IS
and LM curves to the left (to IS1 and LM1 respectively in the figure below), resulting in a
decrease aggregate demand (to Y1D ), but with an ambiguous impact on i. Even with no change
in interest rate, the aggregate supply curve shifts up to Y1S , since devaluation directly increases
variable costs. The combined impacts are a major reduction in output perhaps with an increase
in the price level from p0 to p1. Although the fall in output suggests an expansionary cumulative
effect, devaluation has a direct impact of reducing the monetary base. Tax revenue from trade
increase in terms of domestic currency, while that of BOP surplus is assumed to decline. The net
effect is ambiguous.

4.1.4 Restrictive Monetary policy and Developing Countries
The impact of monetary contraction in the standard LDC model is shown in figure 4.2. An
increase in the reserve ratio, reducing the money supply, has a large impact on the LM curve (for
a given price level) because of the interest elasticity of money demand. The decrease in the
availability of low interest commercial bank loans also reduces retained earning some what
shifting the IS curve down. The new curves are shown in the figure with subscript 1. The
interest rate rises from i0 to i1 and the fall in Y, from Y0 to Y1, shows us the extent to which the
YD curve shifts to the left and that the YS curve shifts upward (see figure 4.1 below)
Fig.4.2 Restrictive Monetary policy
The impact of monetary contraction is thus a relatively small horizontal shift in the aggregate
demand curve. And due to the flatness of the aggregate supply curve, any shift that does occur is
relatively ineffective in reducing the price level. In LDC, this restrictive monetary policy also
raises the aggregate supply curve through the increase in the interest cost on variable inputs. The
net impact of monetary contraction is, for MDC that the price level falls and output declines
moderately; for the LDC output also falls, but the price level may increase.
The cumulating effects on the money supply are expansionary. Thus as time goes on, the initial
impact of the increased reserve ratio, on output will be, reversed and the LDC moves back
toward its initial equilibrium level of income. Therefore such policy is likely to increase both
unemployment and inflation in the short run.
4.1.5 Restrictive Fiscal policy and Developing Countries
While restrictive monetary policy is likely to increase both unemployment and inflation in the
LDC in the short run, restrictive fiscal policy is likely to be more successful in reducing the price
level without the costs of a major recession. A decrease in government spending shifts down the
IS curve, from IS0 to IS1. This results in a small leftward shift in the aggregate demand curve
from YDo to YD1 at Po, but also a shift down in the aggregate supply because i has fallen from io

to i1. The net result is a decrease in the price level and possibly even an increase in output. In
the standard MDC model of course, restrictive fiscal policy reduces both Y and P(See figure 4.2)
Fig. 4.3 Restrictive Fiscal Policy
4.1.6 Income policy and Developing Countries

An income policy that lowers the nominal wage affects the standard LDC economies in a
number of ways.
Shifts the IS curve to the left (since government spending is decreasing)
The LM curve shifts to the right due to a decrease in money demand
It decreases both wage and interest costs shifting aggregate supply down
Then, if the left ward shift in IS is dominates the right ward shift in LM, then there is a decrease
in aggregate demand. If the impact of a decrease in wage on government spending is large, or
there is a substantial difference in the MPC for workers and capitalists then the income policy
will have the impact of decreasing both P and Y. Alternatively, if the shift in aggregate demand
curve is small, then one may get an increase in output and employment. In the standard MDC
model, on the other hand, a decrease in the rigid nominal wage would shift down aggregate
supply curve; output unambiguously rises, while the price level unambiguously falls (see Figure
4.4).
Fig.4.4 Wage Restraint

4.2 Current Macroeconomic Issues in Africa: Introduction to Structural Adjustment

Program (SAP)
1. Introduction
Structural adjustment program refers to the reorganization of institutions, economic activities,

and the entire social system in line with the market-oriented economic system. This program
focuses on two principal issues, namely stabilization and adjustment. Stabilization policies
emphasize on reducing government budget deficit, controlling credit to the economy and the
like. Structural adjustment policies focus on removing constraints on the supply side and pay a
close attention to the production of export crops through a depreciation of the real exchange
rate and other incentives. The main objectives of SAP include revival of economic growth,
reducing macroeconomic distortion, improving economic efficiency and resource allocation and
expanding the productive capacity of the economy.
Structural adjustment programs can be broadly classified into three components, namely
expenditure-reducing policies, expenditure-switching policies and institutional policy reforms.
The expenditure-reducing policies are also known as demand management policies. They are
expected to reduce spending levels in the economy. Such policy measures include stringent
monetary policy, i.e., tight money supply, credit control, and reduced public deficit. These all aim
to curtail domestic demand. The expenditure-switching policies, on the other hand, aim to
redirect productive resources from non-productive sectors to productive sectors or investments.
Such policies include exchange rate devaluation, trade interventions, taxes, tariff, and
deregulation of prices. Finally, institutional policy reforms focus on restructuring of institutions
in order to enhance competitiveness and efficiency through market signals. The required policy
reforms entail trade liberalization, reduced role of the state in the economy, fiscal reform,
privatization, financial market reform, and the like.
Today, the aspects of underdevelopment in Africa look more serious than in any other regions
of the world. The economic situation of Africa is quite dismal, and it looks especially miserable
when compared to the economic achievements of the East Asian NICs. The average per capita
GDP of East Asian NICs in 1995 exceeded $10,000, while that of Sub-Saharan Africa (SSA)
remained only around $500. With these two groups at the opposite extreme, the differences in
the Third World are now such that, as Barbara Stalling puts it, the composite term "Third
World" has become an anachronism. Indeed, it might be said that Africa has now virtually
become the poorest Fourth World.
Africa's economic performance has been very poor especially during the recent two decades.
Moreover, many authors indicate that Africa is still seriously being marginalised from the world
economy in the recent trends of globalisation. How can we account for this phenomenon? Over
this question, the impacts of the Structural Adjustment Programmes (SAPs) implemented by
most African states under the auspices of the IMF and the World Bank, are seriously analysed
and discussed. It is because the SAPs have been the single most important economic policy
during the past two decades that have determined the development course of SSA countries.

The purpose of this essay is to look at the aspects of entrenched underdevelopment in SSA
during recent decades, and to analyse the impacts of SAPs on these aspects. To do this, this
essay will present some general aspects of SAPs first.
2. What are the SAPs in Africa?
Structural adjustment in economic policies, by its own definition, means some measures to
correct problematic sectors and redress the structure of a certain economy. However, after the
1980s, it has been used to refer to the specific sets of economic policies linked to the conditional
loans of the IMF and the World Bank. So, Ankie Hoogvelt writes that "Structural adjustment is
the generic term used to describe a package of measures which the IMF, the World Bank and
individual Western aid donors have persuaded many developing countries to adopt during the
1980s, in return for a new wave of loans".
Since the debt crisis broke in 1982, when Mexico first declared a moratorium on its international
debt payments, the role of the IMF and the World Bank have become increasingly important in
international financial markets, as private creditors hesitated to lend money to risky countries.
This was especially the case with the Least Developed countries in Sub-Saharan Africa.
According to Hoogvelt, the 1980s saw 29 Sub-Saharan African countries accept the IMF/World
Bank medicine. The data of the IMF and the World Bank show that as of the end of 1992, 18
countries in SSA were still accepting the Structural Adjustment credits from the IMF, and 15
countries from the World Bank.
The IMF and World Bank have linked severe conditionalities with their long-term, low-interest
loans. They have demanded the borrowing countries to implement SAPs as a precondition for
their lending. Most developing countries have accepted these conditionalities to get their badly
needed financial resources. In this way, the IMF and the World Bank's intervention in the
economic policies of the debtor countries became matched, perhaps even exceeded the direct
administration of bygone colonial governments.
Consequently, the SAPs have affected the courses of development of the Third World greatly.
And in recent years, many critics raise questions on the intention and results of the SAPs. The
criticism especially gets harsh when it comes to the problems of SSA.
3. Main Tenets and Measures of the SAPs
The SAPs applied to various developing countries have had rather common features in their
measures, under the apparent objectives in the context of international political economy.
According to Adrian Leftwick, the aim of adjustment was to shatter the dominant postwar,
state-led development paradigm and overcome the problems of developmental stagnation by
promoting open and free competitive market economies, supervised by minimal states.
The IMF has focused on stabilization by austerity measures in fiscal and monetary policies, while
the World Bank has emphasized structural adjustment by liberalization and privatization.
Combined focuses of the two institutions have accompanied various measures, all of which have
some common features despite the variety of economic situation of the debtor countries.

Michael Todaro summarizes the four basic components of the SAPs as follows: 1) abolition or
liberalization of foreign exchange and import controls 2) devaluation of the official exchange
rate 3) a stringent domestic anti-inflation program consisting of control of bank credit,
government deficit, wage increases, and dismantling of price control 4) greater hospitality to
foreign investment and international commerce.
Underlying all these components were the neo-liberal tenets of the IMF and the World Bank
that the "principle of free and competitive market" should work throughout all the developing
countries. Considering the Cold War rivalry of the 1980s, it might be said that the SAPs had a
clear message in the context of international political economy: that is, to incorporate all the
developing economies into the system of Western capitalism.
The IMF and the World Bank have explained their packages purely in terms of economic
efficiency. However, most analysts could see the messages entailed in the packages from the very
beginning. So, Samir Amin criticized that "the Berg Report", prepared by the World Bank in
1981 as a theoretical basis of the SAPs, meant nothing but a representation of the interests of
Western capitalists. And now, aside from the political intention of the SAPs, their results of the
past two decades especially in the Sub-Saharan Africa are severely criticised.
4. Economic Performance of Sub-Saharan Africa
Seeing from various statistical data, the present situation of the Sub-Saharan economy is quite
miserable. The World Bank data show that, Africa is the center of "the poverty belt" consisting
of the poorest countries with less than 600 dollars of per capita GDP. Michael Chege writes that
underdevelopment seems determined to make its last stand in Africa. According to Chege, the
overall record of economic growth in SSA was very poor during the past decades. After
registering average annual per capita growth rate of 2.9% in the immediate postindependence
period (1965-73), the rate has since experienced consistent decline, stagnating at 0.1% between
1973-80, and falling by 0.8% on average between 1980-92. At best, therefore, most Africans are
as poor as they were at independence 30 years ago.
Chege shows the cases of 30 countries representing 80% of the Sub-Saharan population. Among
them only 3 countries – Botswana, Lesotho, and Mauritius – managed a per capita growth
record over 3% during the 1970-90 period. Some other countries such as Kenya, Ivory Coast,
Malawi, Rwanda managed moderate growth records throughout the 1970s, but they have also
succumbed to various negative factors over the recent past.
Ibrahim A. Elbadawi and Benno J. Ndulu show similar analysis. They show that, out of 32 SSA
states considered in their joint study, only 6 managed to achieve consecutive positive rates of
growth over the two decades of 1970-90. All other SSA countries have lost at least one decade,
and a significant number of these countries have had two consecutive, negative average, decadal
growth rates. They show even more alarming fact that none of 29 non-SSA countries in their
sample registered negative growth over the two consecutive decades.
The declining per capita income statistics from Africa are accompanied by a wide set of
deteriorating sectoral indicators. According to Michael Chege, the growth rates of African
agriculture and industry also significantly slowed down during the recent two decades. As a

result Africa's world market share for its three main agricultural products – coffee, tea, and
cotton – shrank by 13, 33, and 29% respectively between 1970 and 84. In the industrial sector,
SSA's contribution to global manufacturing value added fell to 0.5% in 1988.
Social indictors also present a depressing picture. Africa's infant mortality rates in 1992 were the
highest of any region in the world, at 107 death per 1,000 live births, compared with 93 for
South Asia, and 7 in Hong Kong. Even though some health standards such as rural child
immunization improved under the auspices of UN Children's Fund (UNICEF), educational
indicators generally aggravated during the 1980s.
Besides these, S.M. Wangwe and Flora Musonda show how much Africa is being marginalized
from the world economy especially in the trends of globalization. They say that the weakness of
Africa's global integration is evident in its falling share of world trade, investment and
Information Technology. Africa's share of world trade varied from 4.1% to 4.9% during the
1960-70s and declined to 2-3% in 1990s. Its share of Foreign Direct Investment in the
developing country-total fell from 11% during 1986-90 to 6% during 1991-93. Net resource
flows also dropped sharply, from $24.1 billion in 1992 to $19.0 billion in 1993 – a fall of nearly
21 per cent. Overall investment in technology is very low. With the exception of South Africa,
the African countries' expenditure on telecommunications equipment in 1986 represented only
0.7% of world spending. Moreover, only a few countries were the main spenders.
5. Causes of the Economic Failure
There are some arguments and disputes about the causes of the poor economic performance of
Africa. Some scholars, especially from the West, indicate internal factors of Africa such as the
poor governance and mismanagement as the most important causes. Michael Chege seems to be
standing on this position when he says that political instability and mismanagement are the best
predictors of economic regress in Africa. He says that there is ample evidence that incumbent
one-party regimes in Africa have squandered opportunities for promoting growth. Even though
he accepts that it may be unrealistic to place too much stress on the link between democracy and
Africa's economic recovery, he still emphasizes his position in the following sentences:
"For the purposes of economic development, what Sub-Saharan Africa really needs is the
replacement of current administrative chaos, managerial incompetence, and corruption with
efficient and reliable governance structures."
This position seems to reflect the reality somehow, but holds more importance as an official
position of the IMF and the World Bank. The World Bank has claimed that the failure of the
SAPs in Sub-Saharan Africa is attributed to the failure of the governance in the countries there.
It claimed that the countries which implemented the policies only partially or not at all, or
backslided, have paid the price with negligible or deteriorating growth. On the other hand, it
claimed, six countries which have followed the guideline faithfully achieved a success by getting
their macro-economic fundamentals right. Those six countries were Ghana, Tanzania, Gambia,
Burkina Faso, Nigeria, and Zimbabwe.
In the 1990s, especially after the collapse of the Former USSR and socialist regimes in Eastern
Europe, such position has had considerable influence on the new aid policies of the Western

industrialized countries. So, France and Britain, the leading source of official development
assistance to Africa, officially announced that their external aid would henceforth be restricted to
countries that observe democratic practice and human rights.
Ankie Hoogvelt criticises this position of 'good governance' or 'democracy initiative' by raising
questions as follows:
"How does this 'democracy is good, state is bad' agenda assist economic reform? The link
between democracy and debt restructuring in the case of Africa is the more puzzling since it
assumes a positive correlation between democracy and economic development. But such
assertions are not made by the leading international organizations when commenting on and
explaining the success of economic development in the newly-industrializing countries of East
Asia. … in relation to that part of the world the new orthodoxy singles out the virtue of strong,
authoritarian and dirigiste states as the most important factor contributing to the development
of the region."
Hoogvelt cites some authors who argue that the emphasis on quality of governance merely
serves as an efficient means of focusing responsibility on government of developing countries,
both for past ills and for implementation of reform packages. Furthermore, he argues that in
many African countries, the imposition of the neo-liberal orthodoxy, including privatization of
the public sector, the emasculation of the state apparatus and the insistence on electoral reform,
has directly contributed to the descent into anarchy and civil wars.
Each position stated above reflects some parts of the reality. As Wangwe and Musonda put it,
the African countries' responses to SAPs differ depending on a number of factors. However, in
any sense, the impacts of the SAPs can not be ignored with regard to the deterioration of the
African economy especially during the last two decades. Many authors indicate that during the
past decades, the SAPs were in fact the single most important development paradigm in SSA.
Barbara Stallings describes a crucial narrowing of development strategy choice that took place
across the Third World after 1980s. Caroline Thomas describes how the domination of neo-
liberal economic policies has affected the changes of the Third World in recent years. Colin
Parkins describes that the debt crisis of 1980s has effectively ruled out alternative responses to
economic development in the Third World.
All these authors indicate directly or indirectly that the SAPs have been the single dominant
economic policy especially in SSA. And the scope and detail of the combined IMF conditionality
rules and the World Bank's structural adjustment contracts have amounted to such a degree of
economic intervention as was cited earlier in this essay from Ankie Hoogvelt. So, Hoogvelt says
that the IMF came to be known as the 'International Ministry of Finance' inside the ruled
countries.
Considering all these facts stated above, the IMF and the World Bank can never be free from
responsibility on the economic deterioration of Sub-Saharan Africa. It might be said that
inadequacy of their policies entailed in the packages of SAPs have greatly affected the
aggravation of SSA economy and have entrenched underdevelopment there.
6. Failure of the SAPs

As we have seen earlier, the failure of the SSA economy in recent decades is too clear to remain
a room for argument over the facts themselves. The IMF and the World Bank try to evade from
criticism on the misguided effects of SAPs by attributing the failure to various other factors
rather than the impacts of SAPs. The ethos of these two institutions seems to be represented in
the following sentences from Michael Chege:
"If the World Bank and the IMF have earned themselves undue criticism and resentment in
Africa over the past decade, it is primarily because they have taken initiatives in the formulation,
financing, and implementation of socially painful economic liberalization programmes in a
frontal effort to meet the onerous development problems."
However, Michael Chege accepts that the effectiveness of SAPs was mixed at best, and he
throws a significant question on the role of the IMF with a following sentence: "Moreover,
because the IMF has become a net recipient of resources from Africa, as debt service exceeds
new loans, it is viewed with suspicion even by the most cooperative governments."
According to Ankie Hoogvelt, even the World Bank itself prepared a report in 1992 under the
title "Why Structural Adjustment has not succeeded in subSaharan Africa?", though it was
retrieved from the publishers and re-issued with a less controversial title. The failure of SAPs in
SSA is analysed by many authors. Kevin Watkins of British Oxfam summarized the whole
process simply in which SAPs have devastated SSA economy and societies as follows:
"... The application of stringent monetary policies, designed to reduce inflation through high
interest rates, has undermined investment and employment. At the same time, poorly planned
trade-liberalization measures have exposed local industries to extreme competition. Contrary to
World Bank and IMF claims, the position of the poor and most vulnerable sections of society
have all too often been undermined by the deregulation of labor markets and erosion of social
welfare provisions, and by declining expenditures on health and education. Women have
suffered in extreme form. The erosion of health expenditure has increased the burdens they
carry as careers, while falling real wages and rising unemployment have forced women into
multiple low-wage employment in the informal sector."
Now let us look at this process more in detail. In the first place, the external liberalization of
SAPs has brought seriously counterproductive effects in many countries. Trade liberalization has
opened door to imports of formerly restricted consumer goods, leading to the destruction of
already weak African industries. Cheaper imports from technologically advanced countries,
especially South-East Asian countries, have made rapid inroads into the African basic consumer
goods markets. Manufacturer's associations in Ghana, Nigeria and Zambia have complained of
dumping and unfair competition. With this, the devaluation of national currencies has made
imports of capital goods and raw materials more expensive, thereby raising the cost of
production. On the other hand, the export specialization policies of SAPs have caused a
flooding of primary commodity markets, which forced prices downwards. During the 1980s, the
terms of trade for SSA commodities fell more rapidly than any other region of the globe. The
effects of financial liberalization measures have been also questionable, since foreign banks have
been hesitant to finance development in Africa.

Finally, forced privatization and financial cutbacks on social security have seriously aggravated
the problem of unemployment, and have lowered the quality of social services such as health
and education. Overall, the SAPs in Sub-Saharan Africa have produced too much negative
effects rather than the positive effects they originally targeted.
5. Conclusion
The SAPs sponsored by the IMF and World Bank have been criticised from the beginning due
to the political intention of the packages. Recently, the focus of criticism seems to have moved
to the real effects what the SAPs have brought to the economies of developing countries,
especially in Sub-Saharan Africa. A lot of evidence shows that they have not only failed to revive
the African economy but have rather entrenched the underdevelopment and poverty there.
The negative impacts of SAPs have affected, among others, the poor and weak masses of the
African societies most seriously. Abolition or reduction of various subsidies on basic necessities
exacerbated the poor conditions of socially weak people. Control of wage increases,
privatization, and trade liberalization measures have all brought combined negative impacts on
the quality of life of the people there.
Hoogvelt argues that despite the failure of the SAPs in Africa, they have been a resounding
success when measured in terms of the process of globalization. The SAPs have helped to tie the
physical economic resources of the African region more tightly into servicing the global system,
while oiling the financial machinery by which wealth can be transported out of Africa and into
the global system. This is an ironical expression of the failure of SAPs to integrate Africa
effectively into the global economy. We have already seen the aspect of marginalization of Africa
from the world economy earlier in this essay. Hoogvelt seems to say that by marginalizing
Africa, the global capitalist system has made it just serve the global system, rather than
participate in the system as an actor.
Seeing from all the aspects we have analyzed as far, the failure of SAPs in Sub-Saharan Africa is
quite clear. Then, what do these findings mean? It means that, at this point, the IMF and the
World Bank should seriously reconsider the neo-liberal principle and directions of SAPs. How
can the principle of free and competitive market unconditionally be applied to the poor
developing countries that have no competitive industrial bases? They should not forget that even
the now industrialized Western countries advocated protectionism for their infant industries
during the early days of their industrialization.
And again, the target of macro-economic stabilisation at the expense of social securities should
be also mediated and redirected. What are the virtues of all economic policies if they bring even
more sorrow and agonies of the already poor and weak people? A serious aspect of this social
impoverishment is that it does not show any sign of improvement over a prolonged time, as the
overall capacity of SSA economy has consistently declined.
These days, some alternative strategies for SAPs are presented by many scholars, and in this way,
new terms such as "Social Adjustment" or "Structural Adjustment with Human Face" are
appearing. It seems that the IMF and the World Bank recently are more susceptive to criticism
on SAPs than in the past. However, there are still strong criticism that these international

institutions are serving the interests of Western capitalists rather than to serve the human welfare
and prosperity. It might be said that this is an inevitably political aspect of international
economic institutions, since the Western industrialized countries are the major shareholders of
all these institutions.
References:
Joo Dong-Joo (1999), Impacts of Structural Adjustment Programmes on the Development

of Sub-Saharan Africa. Internet doc
Porter,R. and S.Ranney, (1982). “An Eclectic Model of Recent LDC Macroeconomic Policy
Analysis”. World Development, 10:9, 751-765
Agnor and Montiel, (1997). Development Macroeconomics,

Chapter-V
BEHAVIOURAL FOUNDATIONS: MORE ON THE

MICOECONOMICS BEHIND MACROECONOMICS
5.1 Consumption And Saving

INTRODUCTION
From the first part we know that we study macroeconomics to understand how the aggregate
economy behaves. We also know that understanding the behaviour of aggregate output is crucial
in achieving this objective and that the “bits” of output that we need to know something about
are contained in the national income accounting identity Y = C+I+G+EX-IM. The component
of this identity is consumption by households, which also makes up the largest part of GDP. As
a result, we cannot hope to understand what determines the long run path of GDP, or the short-
run fluctuations of GDP, without understanding how consumption and savings are determined.
Even without worrying about the aggregate economy, understanding consumption, and thus
savings, as one is the flip-side of the other, is also important because the level of consumption
helps determine the happiness of people today and the level of savings helps determine the
happiness of people in the future. Finally, studying consumption is also important in helping in
analyzing what effects government policies have on consumption and savings behaviour. This
also impacts on interest rates, investment decisions (which are funded out of savings), and hence
the future productive capacity of the economy.
Therefore, How do households decide how much of their income to consume today and how
much to save for the future is a central question in the economics of consumption and saving.
This is a microeconomic question because it addresses the behavior of individual decision
makers. Yet its answer has a macroeconomic consequences since household’s consumption
decisions affect the way the economy as a whole behaves both in the long run and in the short
run. You will see in the next chapter how the consumption decision is crucial for long run
analysis because of its role in determining economic growth.
The consumption decision is crucial for short run analysis because of its role in determining
aggregate demand. We have seen in our discussion of macroeconomics one how the IS-LM
model shows a change in consumer’s spending plans can be a source of shocks to the economy,
and that marginal propensity to consume is a determinant of the fiscal policy multipliers.
In this chapter we examine the consumption function in greater detail and develop a more
thorough explanation of what determines aggregate consumption. To understand this attempt
will be made to present the views of five prominent economists namely, John Maynard Keynes,
Irving Fisher, Franco Modigliani, Milton Friedman and Robert Hall so that it is possible to see
the diverse approaches to explaining consumption.

5.1.1. John Maynard Keynes and the Consumption Function

Keynes made the consumption function central to his theory of economic fluctuations, and it
has played a key role in macroeconomic analysis ever since. Below let’s consider what Keynes
thought about the consumption function, and then see what puzzles arose when his idea were
confronted with the data.
A. Keynes’s Conjectures
Keynes conjectured that the marginal propensity to consume-the amount

consumed out of an additional unit of income- is between zero and one. Keynes
wrote that the “fundamental psychological law, upon which we entitled to
depend with great confidence, … is that men are disposed, as a rule and on the
average, to increase their consumption as their income increases, but not by as
much the increase in their income.” That is, when a person earns an extra unit of
income, he/ she typically spends some of it and saves some of it.
Keynes posited that the ratio of consumption to income, called the average
propensity to consume, falls as income rises. He believed that saving was
luxury, so he expected the rich to save a higher proportion of their income than
the poor.
Keynes thought that income is the primary determinant of consumption and that
the interest rate doesn’t have an important role. This conjecture stood in stark
contrast to the belief of the classical economists who preceded him. The classical
economists held that the interest rate could influence consumption as a matter of
theory. Yet he wrote that “the main conclusion suggested by experience, I think,
is that the short period influence of the rate of interest on individual spending
out of a given income is secondary and relatively unimportant.”
On the basis of these three conjectures, the Keynesian consumption function is often written as
C=Ca+cY, Ca>0, 0<c<1,
Where C is consumption, Y is disposable income, Ca is constant, and c is the marginal
propensity to consume.
Notice that this consumption function exhibits the three properties that Keynes posited. It
satisfies Keynes’s first property because the marginal propensity to consume c is between zero
and one, so that higher income leads to higher consumption and also higher saving. This
consumption function satisfies Keynes’s second property because the average propensity to
consume APC is
APC=C/Y=Ca/Y+c
As Y rises, Ca/Y falls, and so the average propensity to consume C/Y falls. And finally, this
consumption function satisfies Keynes’s third property because the interest rate is not included
in this equation as determinant of consumption.
B. Keynesian Consumption Function(KCF) and Empirical success
Soon after Keynes proposed the consumption function, economists began collecting and
examining data to test his conjectures since the success of any theory and model is that they are

consistent with the relevant real world data. What about the KCF? Sometime after Keynes’
theory had been developed households were surveyed and it was found that:
– 1. Richer households consumed more than poorer ones which implies MPC > 0.
– 2. Richer households saved more than poorer ones which implies MPC < 1.
– 3. Richer households saved larger fractions of their income which implies APC ↓ asYt ↑.
– 4. The correlation between income and consumption was found to be very strong (this was
found during the Great Depression).
So on this evidence the KCF seemed to be consistent with the available real world data about
consumption patterns.
C. THE CONSUMPTION PUZZLE
Unfortunately for Keynes and his KCF, during the 1940s two pieces of evidence were produced
that were not consistent with the KCF’s predictions about how aggregate consumption and
savings should behave:
1. Secular Stagnation Did Not Occur
The first anomaly had to do with a theoretical implication of the KCF that as Y increases, C also
increases but proportionately less than income. This means the pool of savings increases
proportionately as income rose. Since savings equals investment in equilibrium, investment
increases proportionately more than income. But, the problem is that it does not make sense for
firms who want to keep investing if people were buying relatively smaller levels of consumption
goods as their income rose. Thus as Y increased there would be insufficient demand for
consumer goods by people (i.e. people would save “too much” as their incomes rose) and a long
depression of infinite duration (commonly referred to as secular stagnation) would occur. It was
thought that once World War II ended, thus ending the large government demand for goods
and services, that the economy would enter a period of secular stagnation. But, it did not! What
actually happened (i.e. the data) conflicted with the theory of Keynes about how aggregate
consumption depended on aggregate income.
2. The KCF Was Not Consistent With New Time-Series Data.
After Keynes developed the KCF, Simon Kuznet (a Nobel Prize winner) created a set of data
from the US national accounts from 1869 to the 1940s on aggregate Y and C. It showed that C
was a very stable fraction of Y even as Y increased a lot (which implies is approx. constant). This
conflicted with the KCF. The difference arose between this study and the earlier ones that
supported the KCF because the early studies were cross-sectional in detail (they looked at a
snapshot of the economy at a point) whereas Kuznet’s study was of a time series nature (it
looked at the economy over many points in time). So the evidence seemed to indicate that there
were two consumption functions: a short-run consumption function which seemed to conform
to Keynes’s conjectures and a long-run consumption function in which the APC was basically
constant with different levels of Y. We can see how this looks with the following graph:

C Long-run consumption function (constant APC)
Short-run consumption function (falling APC)
5.1.2 Irving Fisher’s Intertemporal model of consumption
To think about aggregate consumption and savings, what could affect them, the best place to
start is to think about the consumption choices of individual people. This was the contribution
of Irving Fisher at the turn of the 20th century and forms the basic framework for thinking
about people’s consumption and savings choices.
He constructed a theory of consumption introspectively (ie. he did not look at data, but just
thought about the issue). His approach was to describe his theory in terms of a mathematical
model. The model was very simple but he thought that it captured the important points in
thinking about the consumption choices of people. Basically economics “forgot” about the work
of Fisher until 1958, 11 years after Fishers death! (life tends not to be fair in many cases!). Note
that it is important to remember that the following theory is about individuals, and not aggregate
consumption per se, but it does have important implications for aggregate consumption because
aggregate consumption is just the sum of consumption by individuals. Note also that a lot of
current work, especially in behavioural economics and neuroeconomics is trying to test the
validity of this framework.
The Basic model:

Optimizing Consumption: A Two-Period Case
Starting from a single consumer with a utility function

U = U (c0… ct …cT)
Where lifetime utility U is a function of his real consumption c in all time periods up to T, the
instant before he dies. The consumer will try to maximize his utility subject to the constraint that
the present value of his total consumption in life cannot exceed the present value of his total
income in life; that is,
Where T is the individual’s expected lifetime. This constraint says that the consumer can allocate
his income stream to a consumption stream by borrowing and lending, but the present value of
consumption is limited by the present value of income. For this restriction to hold as a strict

equality, we assume that if the person receives an inheritance, he passes on a bequest of an equal
amount.
To make the above utility maximization problem analytically tractable, we will take as an
example a particular form of the utility function. Let us assume first that the underlying utility
function is logarithmic, that is,
U(c) = ln c.
This utility function has the usual properties that marginal utility is positive, u’(c) = 1/c, and
diminishing in consumption, u’’(c) = -1/c . Second, we will assume that the utility function is
2
additively separable over time. This means that each period’s marginal utility is independent of
the consumption in all other periods. Third, we assume that future utilities are discounted at the
subjective rate δ. These three assumptions give us the particular specification of utility function
of equation (1) below
The constraint on the consumer’s choices in this many-period case comes from total resources
available: current plus all future income. With no bequests, the intertemporal budget constraint
over the remaining T years of life, in more compact notation, is


5.1.3 Franco Modigliani and the Life-Cycle hypothesis
In a series of papers written in the 1950s, Franco Modigliani and his collaborators Albert Ando
and Richard Brumberg used Fisher’s model of consumer behaviour to study the consumption
function. One of their goals was to solve the consumption puzzle- that is, to explain the
apparently conflicting pieces of evidence that came to light when Keynes’s consumption
function was brought to the data. According to Fisher’s model, consumption depends on a
person’s lifetime income. Modigliani emphasized that income varies systematically over people’s
lives and that saving allows consumers to move income from those times in life when income is
high to those times when it is low. This interpretation of consumer behaviour formed the basis
of his life-cycle hypothesis.
According to this hypothesis, the typical individual has an income stream that is relatively low at
the beginning and end of a person’s life. This typical income stream is shown as the y curve in
the figure below where T is expected lifetime.
On the other hand, the individual might be expected to maintain a more or less constant, or
perhaps slightly increasing, level of consumption, shown as the c line in the above figure,
through out his life. This corresponds to the r > δ path in figure 1. The constraint on this
consumption stream is that the present value of his total consumption does not exceed the
present value of his total income. This model suggests that in the early years of a person’s life,
the first shaded potion of figure 2, the person is a net borrower. In the middle years, he saves to

repay debt and provide for retirement. In the later years, the second shaded portion of figure 2,
he dissaves.
Now if the life-cycle hypothesis is correct, if one is to undertake a budget study by selecting a
sample of the population at random and classifying the sample by income level, the high income
groups will contain a higher-than-average proportion of persons who are at high income levels
because they are in the middle years of life, and thus have a relatively low c/y ratio. Similarly, the
low-income groups will include relatively more persons whose incomes are low because they are
at the ends of the age distribution, and thus have a high c/y ratio. Thus, if the life cycle theory is
true, a cross-sectional study will show c/y falling as income rises, explaining the cross-sectional
budget studies showing MPC < APC or APC falls with a rise in income. Now let us disscuss the
LCH in detail.
INDIVIDUAL CONSUMPTION FUNCTION

The LCH looks at the consumption patterns of individuals over their lifetime. A key assumption
of the theory is that people try and avoid fluctuations in their consumption. The implication of
this assumption is that people will look at their total lifetime income and then borrow or save to
smooth their consumption over time. We can the basic idea behind the LCH in the above graph:
• Simple Example of LCH

To help us understand the LCH better we will now consider a more specific example. Consider a
person who:
Expects to live for another T years.
Has assets presently valued at at (call this current wealth).
Earns yt disposable income this year.
Expects to earn real disposable income of ye from now until retirement in N years time.
Assuming a zero interest rate for simplicity then this person would have lifetime resources equal
to,
and dividing this equally over each period of the life-cycle implies consumption for a person per
period of,
• More General Example of LCH

The previous example is a very simple view of the world since it assumes away a lot of things.
Now consider relaxing some of the strict assumptions and make the model more realistic, in
particular relaxing the following four assumptions:
1. Zero Bequests.
Many parents do not completely run down their accumulated savings in the
later years of their lives. They want to leave some of their wealth for their
children i.e. leave them a bequest. This will make the consumption of the
elderly look smaller than predicted by the simple LCH.
2. Perfect Knowledge of Lifetime.

The elderly, and others, will not completely run down their
accumulated savings if the path of their expenditures is not certain.
They will want to ensure that they have some assets available in case
unexpected expenditures occur. This is called precautionary savings
and will make the consumption of the elderly look smaller than
predicted by the simple LCH.
3. Uniform Consumption.
It may be that consumption demands are naturally higher when
people are old and require medical and home care, or when young
and raising a young family.
4. Zero Real Interest Rate.
The interest rate will affect both the present value of the income
stream as well as the cost of transferring consumption between
different periods. Then we will not get a nice neat relationship
between income and wealth and consumption as before. We will still
get a consumption function for an individual of the same general
form, though, something like:
where,
. b1 > 0 measures the impact of current income on current consumption.
. b2 > 0 measures the impact of future income on current consumption.
. b3 > 0 measures the impact of current wealth on current consumption.
although they do not necessarily equal the same values for the simple version of the
consumption function (which equal 1/T, (N -1)/T, and 1/T , respectively).
• Calculating Permanent Income in the LCH
ADDRESSING THE CONSUMPTION PUZZLE

So now we have to find out how exactly the LCH theory matches up with what we know about
aggregate consumption, and, in particular the aggregate APC. Let the aggregate consumption

function based on the LCH be of the same form as the individual consumption function, but
use capital letters for the macro variables to show that we are looking at the aggregate economy
and not just an individual person, or,
* 2. Over time we would expect the APC to be roughly constant as Yt and At tend to
move together (i.e. At/Yt should be constant). As the income of all people
increases then the total value of the assets they hold tends to increase.
Going back to the short-run APC what we are really assuming is that the value of the intercept is
some function of wealth, and that increases in wealth lift the short-run APC curve upwards,
tracing out the long-run APC curve. This implies that there is no significant change in the APC
over time.
Now we know why Keynes’s theory on aggregate consumption was not consistent with all that
was observed to happen. Keynes’ theory only incorporated differences between people at a

point in time and did not look at changes that could occur to whole economies over time. He
had forgotten the difference between cross-section and time series behaviour.
TESTING THE LCH THEORY OF AGGREGATE CONSUMPTION

• Individual Consumption and the LCH
The LCH theory of individual has not been without its share of criticism, some of it based on
theoretical reasons and some of it based on analysis of individual consumption data. The main
criticism is that people do not seem to smooth their consumption nearly as much as is predicted
by the theory. The main reason given for this is the presence of liquidity constraints*.
One group that tends to be severely liquidity constrained are people who have just entered the
paid work force and have few, if any, assets as well as a relatively low income. This will mean
that the young being liquidity constrained will have consumption in the early (later) part of their
lives look smaller (bigger) than predicted by the simple LCH.
A more recent study by Joseph DeJuan and John Seater (in a 1999 issue of the Journal of
Monetary Economics), however, found using data on 4500 US household from 1986 to 1991
found that the data could not reject the LCH and that there was little evidence of liquidity
constrained behaviour. So the LCH is pretty good at thinking about how individuals choose
their consumption.
• Aggregate Consumption and the LCH

The results about how good the LCH is at explaining aggregate consumption are ambiguous at
this stage. The theory does a good job in many cases of explaining some real world data, such as
aggregate consumption and savings rates across deferent countries that have deferent age
distributions of their populations. It is not as good though at explaining year to year changes in
consumption and savings of a given country. When real world data is used to estimate the
parameters of LCH models the problem of parameter instability over time occurs. This just
means that the estimated values of the parameters (the B’s) describing how aggregate
consumption depends on aggregate income, wealth, interest rates, etc are not always stable over
time. It could be that people are behaving differently, or that the distribution of economic
activity across deferent age groups is changing. This is just an empirical version of the
aggregation problem rearing its head.
1.1.4. Milton Friedman and the Permanent Income Hypothesis
In a book published in 1957, Milton Friedman proposed the permanent income hypothesis to
explain consumer behaviour. Friedman’s permanent income hypothesis complements
Modigliani’s life-cycle hypothesis: both use Irving Fisher’s theory of the consumer to argue the
consumption should not depend on current income alone. But unlike the life-cycle hypothesis,
which emphasizes the income follows a regular pattern over a person’s lifetime; the permanent-
income hypothesis emphasizes that people experience random and temporary changes in their
incomes from year to year.
*
Liquidity Constraint is a restriction on the ability of people or businesses to
borrow

He hypothesized that people’s income has a random element to it and also a known element to
it and that people try and smooth out the random part. This idea was based on his looking at the
differences in year-to-year incomes of farmers and non-farmers.
Friedman suggested that we view current income Y as the sum of two components, permanent
income Yp and transitory income YT. That is,
Permanent income is the part of income that people expect to persist into the future. Transitory
income is the part of income that people do not expect to persist. Put differently, permanent
income is average income, and transitory income is the random deviation from that average.
Consumption can also be classified in the same way as income as permanent and transitory- i.e.
C=C+C .
p T
Assumptions
1. Permanent and transitory income are uncorrelated
2. There is no relationship between permanent and transitory consumption.
3. There is no relationship between transitory income and transitory consumption.
The last assumption states that a sudden increase in income, due to transitory fluctuation, will
not contribute immediately to an individual’s consumption. This assumption is intuitively less
obvious than the other ones, but it seems fairly reasonable, because we are dealing with
consumption as opposed to consumer expenditure. Consumption includes, in addition to
purchases of nondurable goods and services, only the “use” of durables- measured by
depreciation and interest cost- rather than expenditure on durables. This means that if a
transitory or windfall income is used to purchase a durable good, this would not appreciably
affect current consumption. Thus, Friedman assumes that the covariance of CT and YT is zero.
Thus, Friedman reasoned that consumption should depend primarily on permanent income,
because consumers use saving and borrowing to smooth consumption response to transitory
changes in income. Friedman concluded that we should view the consumption function as
approximately
The permanent income hypothesis, as expressed by this equation, states that consumption is
proportional to permanent income. This expression is similar to the life-cycle hypothesis if we
view transitory income as changes in wealth and permanent income as changes in income. The
marginal propensity to consume out of transitory income (wealth) is low; the marginal
propensity to consume out of (permanent) income is high.
The permanent-income hypothesis solves the consumption puzzle by suggesting that the
standard Keynesian consumption function uses the wrong variable. According to the permanent
income hypothesis, consumption depends on permanent income; yet many studies of the
consumption function try to relate consumption to current income. Friedman argued that this
errors-in-variables problem explains the seemingly contradictory findings.
Dividing both sides of the Friedman’s consumption equation by Y to obtain the APC
According to the permanent income hypothesis, the average propensity to consume depends on
the ratio of permanent income to current income. When current income temporarily rises above

permanent income, the APC temporarily falls; when current income temporarily falls below
permanent income, the APC temporarily rises.
Consider the studies of household data. Friedman reasoned that these data reflect a combination
of permanent and transitory income. Households with high permanent income would have
proportionately higher consumption. If all variation in current income came from permanent
component, one would not observe differences in the average propensity to consume across
households. But some of the variation in income comes from the transitory component, and
households with high transitory income would not have higher consumption.
Therefore, researchers would find that high-income households had, on average, lower average
propensities to consume.
Similarly consider the studies of time-series data. Friedman reasoned that year-to-year
fluctuations in income are dominated by transitory income. Therefore, years of high income
should be years of low APC. But over long periods of time- say, from decade to decade- the
variation in income comes from the permanent component. Hence, in long time-series, one
should observe a constant APC.
5.1.5. Robert Hall and the Random-walk Hypothesis
The permanent-Income hypothesis is based on Fisher’s model of intertemporal choice. It builds

on the idea that forward looking consumers base their consumption decisions not only on their
current income but also on the income they expect to receive in the future. Thus, the PIH
highlights that consumption depend on people’s expectations.
Recent research on consumption has combined this view of the consumer with the assumption
of rational expectations. The economist Robert Hall was the first to derive the implications of
rational expectations for consumption. He showed that if the PIH is correct and if consumers
have rational expectations, then changes in consumption overtime should be unpredictable.
When changes in a variable are unpredictable, the varaiable is said to follow random walk.
According to Hall, the combination of PIH and rational expectations implies that consumption
follows random walk.
Hall reasoned as follows: according to the PIH, consumers face fluctuating income and try their
best to smooth their consumption based on their current expectations of their lifetime incomes.
Overtime they change their consumption because they receive news that causes them to revise
their expectations. For example, a person getting unexpected promotion increases consumption,
whereas a person getting an expected demotion decreases consumption. In other words, changes
in consumption reflect “surprise” about life-time income. If consumers are optimally using all
available information, then they should be surprised only by events that were entirely
unpredictable. Therefore, changes in their consumption should be unpredictable as well.

5.2. Investment
INTRODUCTION
Two facts make this one of the most important topics in macroeconomics. First,
investment is usually the most volatile component of GDP/GNP. In many recessions,
the fall in investment is of the same magnitude as the fall in GDP itself. Second, since
physical capital is accumulated through investment, a high level of investment is a
necessary condition for high level of economic growth.
First, let us simply assume the amount of work (capital services) a firm can get from its
capital stock is proportional to the stock. These capital services are then combined with
labour, raw materials, energy, and any other factors to produce output. For
macroeconomic purposes it is worth imagining that capital services (and thus the capital
stock) and labour combine to produce value-added output, Q, so we can write:
Q = Q( K , L),
(1)
QK , QL ≥ 0.
This is a production function, familiar from microeconomics. We assume positive

marginal products that decline with the level of both inputs. Next we need to think about
the process of accumulating capital. First in words:
End-of -period capital stock = Beginning-of-period capital stock – scrapping +

investment.
Now in maths notation:
K t = K t −1 − S t + I t ,
The easiest way to model scrapping it is to assume that a fraction d (for depreciation rate)
of the capital stock is scrapped per period. Assuming that, the above equation becomes:
K t = K t −1 − dK t −1 + I t = (1 − d ) K t −1 + I t ,
5.2.1 CATEGORIES OF INVESTMENT
Before developing any theories about investment choices by people it is important to define
what is meant by investment.
Investment: is the formation of real capital, tangible or intangible, that will produce a stream of
goods and services in the future.
Investment undertaken in an economy is classified according to the following categories:
– 1. Business Fixed Investment — plant and machinery, office buildings.

– 2. Residential Construction Investment — houses, and significant additions to houses (that

require building permits).
– 3. Changes in Firm’s Inventories — as they provide revenue in the future, not today.
– 4. Purchases of Durable Goods by Households — cars, fridges.
– 5. Gov’t Purchases of Investment Goods and Buildings — roads, hospitals, etc.
– 6. Investment in Human Capital — schooling, university study, apprenticeships etc.
– 7. Knowledge — things we know about scientific and other areas.
1. BUSINESS FIXED INVESTMENT

Many people are intensely interested in business fixed investment and it is not difficult to
understand why; it constitutes the basic equipment used by firms to produce output whether it
be computers, factories, machine tools, or offices. We will learn about two theories developed to
explain this form of investment.
A. THE ACCELERATOR THEORY OF BUSINESS FIXED INVESTMENT
The first coherent theory for explaining the level of aggregate investment and why it behaves as
it does is called the accelerator theory of investment. Its initial focus is on what firms might do
and then applies the results to aggregate investment.
Theory behind the Accelerator Model
The theory’s line of argument goes as follows. Firms produce output and they need capital to
produce this output. It is likely that a firm has some desired stock of capital in mind when
producing any given amount of output. If the desired capital stock differs from what the firm
actually has, then it must change its capital stock and how much it changes it is the amount of
investment. When would a firm change how much capital it desired? Following this line of
reasoning the answer is easy, when output changed. Investment is thus the result of changes in
output.
The Formal Model
We will now write the basic idea described above as a formal model. To do this define the
following variables:
. kt = the actual capital stock of the firm at time t.
. kdt = the desired capital stock of the firm at time t.
. yt = output produced by the firm at time t.
. it = the amount of net investment by the firm at time t.
. ά = the desired capital to output ratio by the firm.
Next, we need to specify the two key assumptions used by the model:
. 1. There exists a long-run desired amount of capital related to the amount of output, or,
There may be short-run deviations from this amount because of output fluctuations, but on
average, this relationship holds.

. 2. All investment undertaken today is assumed to be ready for use today (note that this differs
from the “standard” assumption that investment today only becomes productive in the future).
In symbols we can show this as:
and notice the different time subscripts as to why this is true. This is a strong behavioural
assumption that businesses know what is going on all the time and adjust for it very quickly.
Now, put everything together. The logical implication of the second assumption is that the
capital stock each period equals the desired capital stock, or that,
This means that we can rewrite the above equation for net investment in the following way:
So what we find is that investment is determined by changes in output. This is called the naive
accelerator model, since all the change happens in one period.
B. Neoclassical Theory of Investment
Our next theory of aggregate investment, and the one that is currently used by economists,
builds on the accelerator theory but includes the possibility that firms can substitute between
capital and in more sophisticated (and more mathematically complex versions) of this model also
take expectations into account as well, but we will leave that for this course as it requires more
maths than you currently have. The key difference between it and the accelerator theory is that
whereas the accelerator theory did not explore where the desired capital to output ratio came
from, the theory we are about to learn explicitly invokes the optimization principle used in
economics.
Underlying Theory
An important underlying assumption of the accelerator model is that firms do not change their
production techniques. In effect they employ the same proportions of capital and labour
independents of their prices. The neoclassical theory of investment looks at investment decisions
as being affected by output, as with the accelerator model, but on the basis of a cost-benefit
decision. That is, firms may have a desired output level they wish to produce, given the price the
output can be sold at, but the bundle of inputs they use will depend on their relative costs and
benefits so as to maximize the profits of firms.
• The Formal Model

We will now write the basic idea described above as a formal model. To begin with define the
following variables:
. y = the quantity of output produced by the firm.

. k = the quantity of capital used by the firm.

. l = the quantity of labour used by the firm.
. f[·, ·] = the production function which relates how the inputs capital and
labour are used to produce outputs.
Next, we need to specify the key assumption used by the model:
. 1. Firms act to maximise their profits where profits equal revenue less costs.
If firms maximise profits by hiring labor and capital, then the amount they choose to hire will
satisfy the condition MB=MC for each factor, or in this case their MRP equals their cost. Let,
. W = the marginal nominal wage cost paid to employees.
. R = the marginal nominal “rental” cost that firms incur in using capital.
where it is important to note that the implicit or explicit cost of using capital is not simply the
actual price of the capital, since the capital can be resold. The cost of using the capital is the
implicit (or explicit if rented from another firm) cost of renting the capital over the period it is
used we are calling R (e.g. if we build a dam and use it to produce electricity then the capital
cost per unit of electricity is not the total cost of the dam, but some fraction of it relating to
what portion of it was used to produce the unit electricity). Given our assumption, we know that
the logical implication is that capital and labour are employed up to the point where.
There are three cases to consider:

. 1. MPK > cost of capital means there are potential profits a firm could earn by increasing its
capital stock.
. 2. MPK < cost of capital means the firm is making losses on the last units of capital it is using
and it could increase profits by reducing its capital stock.
. 2. MPK = cost of capital means the firm is maximizing the amount of profits it can earn from
using capital and does not want to change its capital stock (ie. kt+1 = kt).
And so a firm’s decision about whether to add to its capital stock, or reduce it through
depreciation depends upon the profit rate or the difference between the MPK and the cost of
capital. Note that unlike the accelerator theory, the neoclassical theory shows us what determines
the optimal or desired capital stock, it is the amount of capital where MB=MC, or no more
profits can be made from changing the firm’s amount of capital.
Investment and the Capital Stock

A logical conclusion from the neoclassical theory of investment is that both net and gross
investment of firms are a negative function of r because the cost of capital is positively affected
by changes in r, which negatively affects the profit rate of capital.
And a change in any other variable that affects the MB or MC of using and owning capital by
firms in an economy other than r can be shown by a shift of the investment function (e.g. an

increase in the MPK, say from a technological innovation, causes a rightward shift in the
investment schedule.
The amount of investment that is undertaken depends on whether or not firms are using and
owning the optimal amount of capital, that is, whether or not the profit rate is zero or non-zero.
In the long-run equilibrium, with the profit rate equaling zero, we would expect that the amount
of net investment is zero with gross investment being positive and just offsetting the amount of
depreciated capital each period. Once a firm is in its long-run state, only a change in r, or
MPK, or some other variable, will affect the demand for capital and thus the amount of
investment demanded. This will cause net investment to stop being zero and the capital stock
will adjust to get back to a new long-run equilibrium situation.
2. INVENTORY INVESTMENT
The last category of investment that we will study is inventory investment. It is not that large
compared to the other forms of investment, but as mentioned at the beginning of this topic
there is a strong relationship between changes in inventory investment and changes in output
over the business cycle.
A. REASONS FOR HOLDING INVENTORIES

Before developing a theory of inventory investment we will study the reasons why inventories
are held. Knowing the reasons for holding inventories will help us understand better the factors
which influence the level of inventory investment. There are four reasons for holding
inventories:
– 1) Production Smoothing.
. Often it is cheaper to produce goods at a steady rate, than to continually alter production runs.
This means that during slow periods inventories build up and during boom periods inventories
are run down.
– 2) Inventories as a Factor of Production.
. Firms carry inventories of spare parts in case a machine breaks down, so that the entire
assembly line does not come to a stop. eg. Car assembly factory.
– 3) Stock-Out Avoidance.
. To avoid lost sales and profits when sales may be unexpectedly high. E.g. a book retailer may
carry multiple copies of a book if they are not sure how popular the book will be.
– 4) Work In Process.
. Partly completed products are counted as inventories eg. cheese making where cheeses are
aging.
An important point to notice about all of these reasons is that have a short-term focus and not a
long-term focus as with the other forms of investment. This suggests that they will not be so
heavily influenced by short-run changes in relative prices but will instead be tied closely to
output. Another point to note is that reason 1.is not likely to be an important reason why
inventories fluctuate during business cycles since this sort of inventory investment goes up as
output goes down whereas inventory investment as a whole goes down as output goes down.
This means 2.-4 must be the main causes of fluctuations in inventory investment during a
business cycle.

B. ACCELERATOR THEORY OF INVENTORY INVESTMENT
• Theory Behind The Accelerator Model

You have seen this theory before applied to a different setting. The idea is the same except in
the case of inventory investment the reason that firms might hold stocks of inventories that are
proportional to their levels of output seem to have more justification than did the case of
business fixed investment, for the reasons mentioned above which are directly related to the
level of output being produced and sold. For example, say output is high and the economy is
booming then production firms require more supplies, and have more work in process and retail
firms want more merchandise to keep up with the higher sales.
Furthermore, it is likely that firms can change their inventory investment much more quickly
than they can change their fixed investments.
There may be short-run deviations from this amount because of output fluctuations, but on
average, this relationship holds.
and notice the different time subscripts as to why this is true. This is not as strong a behavioural
assumption in this context as it was in the context of business fixed investment. If we are
thinking of periods of time being a year then most .firms can alter their inventories to changing
conditions very quickly if they choose to do so.

So what we find is that a firm’s inventory investment is determined by changes in output. This is
again called the naive accelerator model, since all the change happens in one period.
3. James Tobin and the Q- theory
Many economists see a link between fluctuations in investment and fluctuations in the stock market.
The term stock refers to the shares in the ownership of corporations, and the stock market is the
market in which these shares are traded. Stock prices tend to be high when firms have many
opportunities for profitable investment, because these profit opportunities mean higher future
income for the shareholders. Thus, stock prices reflect the incentive to invest.
During a period of adjustment to a higher optimal level of capital, the marginal product of capital is
above marginal or user cost. Put another way, this means the firm’s capital is worth more (being
more productive and thus more profitable) than its user cost. James Tobin, the Nobel laureate,
argued that during such a period, the firm’s stock market value would be high, reflecting the high
value of the firm’s existing capital. Tobin defined a value q as the ratio of the present market value
of the firm’s capital to its replacement cost i.e.
q= market value of installed capital/replacement cost of installed capital

MPK − d
or, q =
r
The numerator of Tobin’s q is the value of the economy’s capital as determined by the stock market.
The denominator is the price of the capital if it were purchased today.
Tobin reasoned that net investment should depend on whether q is greater or less that 1. if q is
greater than 1, then the stock market values installed capital at more than its replacement cost. In
this case managers can raise the market value of their firm’s stock by buying more capital.
Conversely, if q is less than 1, the stock market values capital at less than its replacement cost. In this
case, managers will not replace capital as it wears out.
Although at first the q theory of investment may appear quite different from the neoclassical model
we developed earlier, in fact the two theories are closely related. To see the relationship, note that
Tobin’s q depends on current and future expected profit from installed capital. If MPk exceeds the
cost of capital, then firms are earning profit from their installed capital. These profits make the
rental firms desirable to own, which raises the market value of these firms’ stock, implying a high
value of q. similarly, if MPK falls short of the cost of capital, then firms are incurring losses on their
installed capital, implying a low market value and a low value of q.

5.3 The Government Sector
1. INTRODUCTION
So far we have just treated the government as some benign device that mechanistically and
benevolently determines fiscal and monetary policy without any constraints. In fact life is more
complicated than this because:
– Tax levels are constrained by the effects that the taxes have on the efficiency with which an
economy produces output.
– Tax and debt changes may not have any net effects on aggregate demand and hence output.
– Governments may not be benevolent and as a result their policies may not be optimal from
society’s point of view.
These suggest that there is more to the activity of the public sector than we have let on so far
and we’ll examine some topics in public sector economics to see how a more realistic treatment
of the government sector impacts on how government policies affect the aggregate economy.
Doing so will also help you to see why the reforms in most African countries, starting after 1991,
such as the Structural Adjustment Programs took the form that they did.
2. THE LAFFER CURVE

Our treatment of government taxation in the AS-AD model has been highly unrealistic as we
have been assuming that governments can arbitrarily set the tax rate to be what it wants. In
particular, we have been assuming that taxes levied by the government are lump sum, or a fixed
amount per person no matter who they are or what they do. This implies that they do not affect
people’s marginal decisions and hence do not affect economic efficiency per se hence why the
government can effectively collect any level of taxes that it desires, which is unrealistic!
In practice, governments use marginal tax rates, not lump sum taxes. This means that the taxes
levied by governments affect people’s marginal decisions, and hence economic efficiency. This
also implies that governments face constraints about the level of taxes they can collect because:
– They do not want to alienate too many voters.
– They are worried about emigration of skilled or wealthy citizens.
– They do not want to make working unattractive.
– They do not want to make saving or investing in capital unattractive.
Thus an important choice for a benevolent government is what the optimal marginal tax rate is.
What we are going to do now is see what happens when governments don’t use lump sum taxes
and also when there are constraints on the amount of taxes they can levy. This introduces a lot
more realism into the tax picture.
A. THEORY BEHIND THE LAFFER CURVE
Analyzing how changes in the marginal tax rate affect total taxes levied was thought of by
economist Alfred Laffer who apparently wrote his theory down on a napkin in a restaurant in
the US! The resulting Laffer curve relates marginal tax rates to total tax revenue (see figure
below).
The Laffer curve is a curve which supposes that for a given economy there is an optimal income
tax level to maximize tax revenues. If the income tax level is set below this level, raising taxes

will increase tax revenue. And if the income tax level is set above this level, then lowering taxes
will increase tax revenue. Although the theory claims that there is a single maximum and that the
further you move in either direction from this point the lower the revenues will be, in reality this
is only an approximation.
The above curve shows that tax revenues are the product of the tax rate, t, and the tax base, x,
written as a function of the tax rate and it also tells us that tax revenues have a maximum where
the marginal tax revenue is zero i.e.
The concave shape of the curve occurs for the following reasons:

Note the following:

– There will also exist ranges of tax rates for which increases in the marginal tax rate lead to
decreases in total tax revenue.
– There will also exist ranges of tax rates for which decreases in the marginal tax rate lead to
increases in total tax revenue. On some occasions it has been argued in various countries that
the latter situation holds, but it could be just a way of trying to justify policies that are really
electoral bribes!
B. EVIDENCE REGARDING THE LAFFER CURVE

There is clear evidence that there is a hidden economy in most countries. It also seems clear that
the size of the hidden economies is related to the incidence of taxes in the economies.
It must be noted though that the relationship is not perfect, because of:
1. Different Cultural Norms.
. i.e. honesty is valued more in some countries than others.
. i.e. governments are seen as beneficial in some countries and as enemies of freedom in others.
2. Differences in Expected Costs of Evasion.
If the chance of being caught evading tax is high and the penalty is high then the expected cost
of tax evasion is high and then there will be relatively low amounts of such evasion. So the
incidence of evasion depends on the number of tax auditors and the penalty of being caught
evading taxes.
3. Differences between National and effective Tax Rates.
Some countries may have high notional tax rates, but because of substantial tax breaks, the
effective tax rates may not be that high.
3. RICARDIAN EQUIVALENCE
There are different theories or views regarding the government sector particularly the economics
of taxation and government debt. The traditional view presumes that when government cut
taxes and runs a budget deficit, consumers respond to their higher after tax income by spending
more. An alternative view called the Ricardian equivalence, questions this presumption.
According to this view, consumers are forward-looking and, therefore, base their spending not
only on their current income but also on their expected future income. Therefore, below
attempt is made to discuss this view in detail.

We have seen in the IS-LM/AS-AD model that a decrease in taxes, say lump sum taxes, causes
an increase in AD and hence in income and output. This may not in fact actually occur, and may
just be an artifact of our static model which does not explicitly include government debt. The
reason it may not occur is because it turns out that T may not accurately measure the incidence
of government taxation, and that what really matters is the level of government spending, and
not how it is financed. This is the notion of Ricardian Equivalence, and, if it holds, this would again
impact on how a government undertakes its fiscal policy.
Ricardian Equivalence is the theory that aggregate consumption, and therefore aggregate savings
and interest rates, are independent of whether government spending is financed by taxes or by
borrowing. Or to put differently, the Ricardian equivalence proposition states that deficits and
taxes are equivalent in their effect on consumption. Lump-sum changes in taxes have no effect
on consumer spending, and a reduction in taxes leads to an equivalent increase in saving. The
reason is that a consumer endowed with perfect foresight recognizes that increase in
government debt resulting from an increase in government spending or a reduction in taxes will
ultimately be paid off by increase taxes. Taking the implied increase in future taxes into account;
the consumer saves today the amount necessary to pay them tomorrow. Ricardian equivalence
implies, in particular, that fiscal deficits have no effect on aggregate saving or investment. or
consequently, through the economy wide saving-investment.
The conditions required for Ricardian equivalence to hold are the existence of:
Infinite planning horizons
Certainty about future tax burdens
Perfect capital market (or the absence of borrowing constraint)
Rational expectations
Non distortionary taxes
We will now look at why people argue that Ricardian Equivalence might hold.
The first step is to realize that the government has a budget constraint: each year, government
expenditure must equal its funding. In general terms we can write the government budget
constraint as,
Spending on Goods & Services+InterestCosts+RepayingDebt=NetTaxes+NewDebt+PrintingMoney
where the last source of funding is known as the inflation tax because printing money invariably leads to
inflation causing a decrease in the purchasing power of people’s money holdings.
It is this decrease which the government “confiscates” from people for it to use to fund its
expenditure. Think of time consisting of three periods: the past (denoted by p), the current
(denoted by c), and the future (denoted by f). In symbols, this budget constraint in real terms
looks like,
where i is the nominal interest rate and P is the price level. What we will do now is look at an
example using a simplified example of this budget constraint. Now assume the following to
focus attention on the key variables underlying Ricardian Equivalence:

Now assume that the government decreases Tc by $1. The disposable income of households
must increase by $1 in the current period as a result and in fact at a first glance it looks as though
the PV of taxes has gone down. To check on this though let us look at (1). The LHS is fixed
since government spending on goods and services, and the debt it has inherited as to be repaid
with interest. This means something else has to change on the RHS. What changes is that
government debt increases by $1 (it could print money, but this is not the area of interest here).
The implication of this is that the LHS of (2) increases by $(1 + r) to reflect the increased debt it
has to repay and on which it has to pay interest. This means that the RHS of (2) has to increase
by $(1+r). The government cannot borrow because it has to repay all its debt in the future (and
again it could print money but this is not the area of interest). As a result, taxes in the future
must increase by $(1 + r).
So for a given stream of government spending, a decrease in taxes today will lead to higher taxes
in the future!

which is exactly the same as before. Since the PV of taxes has not changed, aggregate
consumption and saving will not change, hence the interest rate and aggregate investment will
not change. Changing the assumptions does not affect the result; it just makes the algebra more
complicated. The timing of the taxes changes by varying the size of the deficit, but not the
present value of the taxes. Hence people are no better off if taxes are lowered today, only to be
increased sometime in the future.
Note: there is one exception to this basic fact. We have been assuming that taxes are lump-sum
above. This means that they have no distortionary effects on people’s decisions, but in the real
world, taxes are not lump-sum, and hence are distortionary. Thus it may pay a government to
run a temporary deficit to meet a cyclical shortfall in revenue, rather than increase the tax rate
and increase distortionary losses (i.e. this is related to the Laffer curve type of effect). But how
often do you see governments saying things like this?! Anyway, this would imply that
governments run a surplus in boom times, which they do not in virtually all countries, and
during most of our history.
A. REASONS WHY RICCARDIAN EQUIVALENCE MAY NOT HOLD
Riccardian Equivalence is based on two assumptions about people’s behaviour holding
In reality people only live for a finite period and so may not care about the future. The government could
decrease taxes now, and increase taxes that the next generation faces. The current generation would then
be wealthier, and hence consume more and save less. If people care about the next generation
(usually shown through a bequest motive, or investment in their children’s human capital), then
this affect is moderated. If people care greatly about their children, then their preferences may
be aligned and hence we are back to the world of Ricardian Equivalence.

This raises interesting economic questions relating to the impact of demographic choices such as
what do we expect to happen to savings, investment, output, and the like if fewer people are
having children?
B. EVIDENCE CONCERNING RICARDIAN EQUIVALENCE
There is some evidence that RE holds, and other evidence that it does not. The major problem
in trying to figure out whether or not RE holds is because of problems measuring what they
want to measure to test the Ricardian Equivalence theory.
There are three main areas with measurement problems:

– 1. Problems Measuring Savings: Need to calculate savings, and normally
it is done by Y - C, but a lot of measured C is actually I (e.g. durable goods) so our measured
savings, Y - C understates the amount of true savings that is undertaken.
– 2. Problems Measuring Bequests: Bequests are measured by the amount of assets that are
passed on by their parents, but a lot of the assets passed on have been done so before the
parents die, such as education and parenting of the children, which are very difficult to measure.
This underestimates the true size of bequests.
– 3. Problems Measuring Superannuation: Publicly funded superannuation reduces the
amount of saving by people as they do not need to save as much because the government will
look after them. So we can never be sure that changes in people’s savings are due to changes in
deficits, or to government changes in its provision of superannuation?
Ricardian Equivalence and Developing Countries
The available evidence for developing and industrial countries has failed so far to provide much
support for Ricardian equivalence hypothesis. The evidence from industrial countries appears to
be largely inconclusive (Seater, 1993). In developing countries where financial systems are
underdeveloped and, capital markets are highly distorted (even non existent in Ethiopia) or
subject to financial repression, and private agents are subject to considerable uncertainty
regarding the incidence of taxes, many of the considerations necessary for debt neutrality to hold
are unlikely to be valid. The empirical evidence has indeed failed to provide much support for
the Ricardian equivalence proposition. Haque and Montiel (1989) reject the null hypothesis of
debt neutrality for fifteen out of a group sixteen developing countries. Veidyanathan ((1993),
using a group of almost sixty countries and annual data covering three decades, Corbo and
Schmidt-Hebbel (1991), and the empirical studies reviewed by Easterly and Schmidt-Hebbel
(1994) for the most part also fail to detect the significant effects of public deficit on private
consumption. Both Haque and Montiel and Veidyanathan suggested that consumers in
developing countries are subject to liquidity and borrowing constraints.

Appendix: A Mathematical Treatment of the Ricardian Equivalence

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Reading Materials Macroeconomics- I and II (Econ-221 and 222)

1.2 The State of Macroeconomics: Evolution and Recent Developments

Schools of thoughts in Macroeconomics

Instructor: Getachew A. Department of Economics, Arba Minch University 1

Keynesian’s View of the Economy1

Instructor: Getachew A. Department of Economics, Arba Minch University 2

Keynes and Economic Policy

Instructor: Getachew A. Department of Economics, Arba Minch University 3

Policy Rule under Monetarism

The New Classical School

The New Keynesians

Instructor: Getachew A. Department of Economics, Arba Minch University 4

A long tradition in macroeconomics (including both Keynesian and monetarist perspectives)

Menu Costs and Aggregate-Demand Externalities

Instructor: Getachew A. Department of Economics, Arba Minch University 5

The Staggering of Prices

Instructor: Getachew A. Department of Economics, Arba Minch University 6

Instructor: Getachew A. Department of Economics, Arba Minch University 7

Recent Developments in Macroeconomics: Breaking of the consensus

Instructor: Getachew A. Department of Economics, Arba Minch University 8

1.3. Basic Concepts and Methods of Macroeconomic Analysis

Real GDP versus Nominal GDP

Instructor: Getachew A. Department of Economics, Arba Minch University 9

Gross and Net Domestic Product

Instructor: Getachew A. Department of Economics, Arba Minch University 10

The Business Cycle and the Output Gap

Instructor: Getachew A. Department of Economics, Arba Minch University 11

Inflation –Unemployment Dynamics: The Phillips Curve

Case study: The Phillips curve for Ethiopia

Instructor: Getachew A. Department of Economics, Arba Minch University 12

Mankew, G.(2002). Macroeconomics, 5th ed., worth publishing

Mankew, G (1988). “Recent Developments in Macroeconomics: a very quick refresher course”.

Mankew, G (2002). “The New Keynesian Economics”. The Concise Encyclopedia of

Instructor: Getachew A. Department of Economics, Arba Minch University 13

Some important identities

A Simple Economy Model

The saving- investment balance

Instructor: Getachew A. Department of Economics, Arba Minch University 14

An Economy with Government and Foreign Trade

Instructor: Getachew A. Department of Economics, Arba Minch University 15

Thus, there is no inevitable one-to-one link between the two deficits.

By moving G to the right hand side we can arrive at

Instructor: Getachew A. Department of Economics, Arba Minch University 16

2.2. Aggregate Demand Analysis

2.2.1 The Goods Market and the IS Curve

2.2.1.1. The Keynesian Cross

Instructor: Getachew A. Department of Economics, Arba Minch University 17

The Economy in Equilibrium

Actual aggregate demand = Planned aggregate demand

Instructor: Getachew A. Department of Economics, Arba Minch University 18

2.2.1.2. Derivation of the multipliers

Instructor: Getachew A. Department of Economics, Arba Minch University 19

I+G=Y- C(Y-T(Y)) = S(Y-T(Y)) +T(Y) ------------ (4)

B. Fiscal Policy and the Multiplier: Government Purchases multiplier

Instructor: Getachew A. Department of Economics, Arba Minch University 20

Instructor: Getachew A. Department of Economics, Arba Minch University 21

C. Fiscal Policy Multiplier: Tax multiplier

D. Derivation of the Balanced Budget Multiplier

Instructor: Getachew A. Department of Economics, Arba Minch University 22