Chapter 5 : Overview of Macroeconomics

5.1. Definition of macroeconomics

 macroeconomics is the study of the behaviour of the economy as
a whole.
 An economy that has successful macroeconomic management
experiences low inflation and unemployment as well as steady
and sustainable growth.
 In contrast, in a country where there is macroeconomic
mismanagement, it has adverse impact on the living standards
and employment opportunities of the citizens of that country.
 5.2 National Income Accounting

 National income accounting is accounting system that

is used to measure aggregate economic activities.

 It is an official measurement of the flow of income

and product in a given economy. Aggregate economic

activity or total output (income) of an economy for

given period of time can be represented by GDP/ GNP

 Gross Domestic Product (GDP) is the market value of all final

goods and services produced in a country in a given year.

 On the other hand Gross National Product (GNP) is the total

market value of goods and services produced by the

nationality of a given country for a given period of time

 GNP would includes some output produced by a citizen of a

country living abroad and excludes the output produced by

the nationality of other country under taking production in

that country
 GNP =GDP+ Net factor payment (NFP).
 Where net factor payment or income is the difference
between factor payment from abroad and to abroad
 In other words payment of factor income to the rest of
the world subtracted from receipts of factor income (wage,
profit and rent) from the rest of the world.
 For example Ethiopians who own apartments in New York
earn rental income for their building.
 This income earned included in GDP calculation of US but
not part of GNP of USA but it is included in GNP of Ethiopia.
5.3.Measuring GDP

 How can we measure GDP/GNP of an economy?

 Approaches of measuring GDP

There are three methods result in the same value of GDP

since the expenditure of one agent becomes the income for

others.

I. Income approach

II. Expenditure approach

III.Product or value added approach

I. Income approach
 In this approach the returns (income) to factors of production (labour,
entrepreneur skill, Land and capital) sum up get total output produced in a
given economy per unit of time.
wages and salaries (payment for labour) +rents(payments land, building and
other capital input) + interest income ( saving deposit) +pprofit (payments
made to the owner of firms in return to the output produced).
The following table represents an example of GDP computation for hypothetical economy using
income approach.
Table 1.1. GDP of hypothetical economy in billions of dollars
Component of GDP Values in dollars
Wages and salaries $6,657.4
Rents $153.8
Interest rate $ 546.7
Profit $2,020.9
Plus depreciation $ 1,479.9
Plus Indirect business tax $885.9
Plus statistical discrepancy $90.4
GDP $11,835.00
II. Expenditure approach
 According to this approach, the value of total output in the
economy can be measured by aggregating expenditure made on
final goods and services in the product market.
 This demand (expenditure) for domestically produced goods
comprise of four main components depending up on who makes
the expenditure.
 These are
I. consumer expenditure (C)
II. Business investment (I)
III. Government expenditure (G)
IV. Foreign expenditure or net export (NX)
I. Consumption spending (C) : is the spending made on
domestically produced final goods and services by household
II. Business investment spending (I) :is spending made on goods
and services which are used for production of other goods.
III. Government purchase or spending (G): is spending made on
domestic goods and services by federal, state and local
government.
IV. Net export (NX) :represents the value of goods and services
exported minus value of other countries produces and supply
to us.
GDP=C +I +G + NX.
 Table GDP and it components, in $ billions in 1987 for USA

Component of GDP Amount of spending

 Personal consumption expand………………………………………….$4527.00

o Durable goods……………………………………… $3012.00
o Non durable goods…………………………………… $422.00
o Services goods…………………………………………$998.00
 Business investment………………………………………………………$713.00
o Business fixed investment ……………………………$713.00
o Structures………………………………………………$447.00
o Producers durables……………………………………. $140.00
o Residential Structure………………… ………………. $307.00
 Net export…………………………………………………………………$123.00
o Exports……………………………………………….…$482.00
o Import…………………………………………………..$551.00
 Government spending…………………………………………………....$925.00
Federal Gov’t spending…………………………………..$382.00
National defence……………………………………$295.00
Others………………………………………………. $ 87.00
State and local………………………………………$543.00
III. Product or value added approach
 Production of goods and services involves a distinct stages.
 Each stage involves separate market transaction and flow of
income.
 For example as indicated in table below, there are four different
stages having their own market transaction in production of bread.
Table 1.3. Production of bread involving four different stages.

Stage of production Value of transaction Value added

1. Farmer grows wheat and sell
And sell to miller ……………….$0.12……………… $0.12
1. Miller converts wheat to
Flour and sell to baker………………$0.28………………. $0.16
2. The baker bake bread and
Sell to store owner…………………. $0.60……………….. $0.32
3. The store sells bread to the ……… $0.75………………… $0.15
$1.75 $0.75
 we add up separate value of each market transaction we would come to
the conclusion that the value of output produced in production process
equal to $1.75 even though the output produced is equal to $0.75

 This example show that there is a problem of double count if we uses

intermediate goods for calculation of GDP rather than using final goods
and services or the value added in production.

 Therefore to measure GDP more accurately we must distinguish between

intermediate and final goods and services before we start aggregating
together the value of output produced.

 The value of most goods and services during GDP accounting computed
at market prices. However some goods have no market price and don’t
have market where they sold. So to include such goods in GDP, their
values are estimated using different proxy measures. For example the
services of own house and police officer have no market price. Their
value should be estimated using some proxies to add to GDP.
 Lastly, there are goods and services produced but hidden from
government such section of the economy is said to be the
underground economy (informal economy).

 In case of under developed countries there is output/income

creation in billions of dollars in the underground economy. Such
good however have no market value and cannot be imputed.

 As a result output produced in underground economy left from

computation of GDP.
5.4. Other measures of output/income

 Alternative to GDP, there are other measures that are used to

represent the total output produced in an economy. Let us
identify how to determine these measures based on GDP.

I. Net domestic product (NDP)

II. Net national product (NNP)-

III. National Income (NI)

IV. Personal income

V. Disposable personal
I. Net domestic product (NDP) – It represent the value of total output
of an economy after net out depreciation.

 NDP=GDP - depreciation.

II. Net national product (NNP)-measures the value of total output

produced by a citizen of a given country within a specified time period after
subtracting the consumption of fixed capital (depreciation).

 NNP=GNP – Depreciation

III. National Income (NI) – It is the total income earned by resource

owner from current production. Can be determined in two ways

 NI= NNP-Indirect business tax (e.g. sales tax)

 NI= GNP - Depreciation – Indirect business tax

 NI=wages and salaries + proprietors income + Rental income
+corporate profit +Interest income.

IV. Personal income is the amount of income that households and

non corporate businesses receive.

 Personal income (PI) =National Income-corporate profit -Social

-Insurance contributions-Net interest + Dividend +
Government transfer + Personal interest income

V. Disposable personal income- Households non corporate business

income that is really to spend after tax and non tax payments.

 Disposable income (DI) = personal income -Personal tax and

non-tax payments

 DI = consumption + saving
5.5. Nominal and real GDP

 The aggregate that is obtained by measuring economic activity

at current market price is termed as nominal GDP.

 Consider for example an economy producing only two goods

banana and coffee. To find a nominal GDP of such economy,
simply sum up the total value of banana and coffee at current
market prices.

 That is, nominal GDP = (Price of banana x Quantity of banana) +

(price of coffee x Quantity of coffee).

 The problem with such type of valuation of goods and services

is that it could not reflect the cause for change in GDP
resulted from change in price or change in quantity of output
overtime.
Table , the total amount of output of two goods economy with their
market prices of hypothetical economy.

Year Price of Quantity of Price of Quantity of

banana/kg banana(tone coffee/kg coffee(tone)
)

2004 2.00 10,000.00 5.00 20,000.00

2005 2.50 10,500.00 8.00 20,500.00

2006 3.00 10,600.00 10.00

20,600.00
2007 5.00 10,600.00 30.00
20,600.00
 Let us compute the nominal GDP of the economy for 2006 and 2007 to
see the impact of price on the value of total output (GDP).

 Nominal GDP of 2006 = (2006 price of banana x 2006 amount of

banana) + (2006 price of Coffeex2006 amount of coffee). = (3x10,
600) + (10x20, 600) = 31,800+206,000 =237,800
 Nominal GDP in 2007 = (2007 Price of banana x 2007 amount of
banana) + (2007 price of banana x amount of coffee in 2007) = (5x10,
600) + (30x20, 600) =53,000+618,000 =671,000

 This example show that the nominal GDP in 2007 increases without an
increase in the amount of output produced because of increase in price.

 A better way of measuring the state of an economy is measuring the

economy’s total output by avoiding the impact of price.

 This can be possible by using real GDP. Real GDP is the value of goods
and services measured using constant or base year price.
 For instance, let us set a base year price for the above
hypothetical economy to be 2004, then the real GDP of 2006 and
2007 can be computed as follows.
 Real GDP= (2004 price of banana) (2006 Quantity of banana) +
(2004 price of coffee) +(2006 Quantity of coffee) = (2x10, 600) +
(5x20, 600)= 21,200+103000=124,200
Real GDP= (2004 price of banana) (2007 quantity of banana) +
(2004 price of coffee) (2007 ) (Quantity of coffee) = (2x10, 600)
+ (5x20, 600) =21,200+103,000= 124,200

 When price held constant, the real GDP varies from year to year
only when the quantities produced vary.
 5.6. GDP Deflator and Other Measures of General prices

Economist and policy makers use change in general level of price to measure the performance of
an economy in combination with the level of GDP. To measure the general price of an economy
they use GDP deflator and consumers and producer price index.
GDP deflator
GDP deflator also called the implicit price deflator for GDP is defined as the ratio of nominal
GDP to real GDP.
No
mi
nald
GDPP
Q P
GDP deflator = R  
e
alGD
P PQ
b Pb

Where P-current price of goods, Pb-base year price and Q-Quantity of good produced.
GDP deflator measures the price of output (goods) relative to its price in the base year. It shows
whether the price of goods increase or decreases in reference to the base year price.
For the hypothetical economy represented by table 1.3, GDP deflator for year 2006 computed as:
N
om
ina
lGD
P o
f20
06
GDP Deflator of 2006 = Rea
lGDP
of2
006

237,800
=  1.915
124,200
This means there is an increase general level of price by 191.5 percent in 2006 relative to
general price of 2004.
As the name indicates it also used to deflate nominal GDP to get real GDP.
NGDP
Real GDP=
GDP deflator
Consumer price index (CPI)
CPI is the most commonly used price index to measure the general price level of an economy. It
represents price of a fixed basket of goods and services purchased by a typical consumer relative
to the same basket of goods and services in some base year. For example if a typical consumer
buy 10 unit of Banana and 3 unit of coffee then the CPI for the two consumption good can be
computed as:

10  current price of Banana 3 current price of coffee

CPI= 
10  baseyear price of Banana 3 base year priceof coffee
 Alternative to consumer price index, cost of producer goods would be
measured by an index called producer price index. Producer price index
measures the price of typical basket of goods bought by firms.
Short comings of GDP/GNP as a measure of social welfare
 Both nominal and real GDP/GNP cannot serve as a good instrument for
measuring the welfare changes of a society.
I. They both lack in indicating the composition of output in the current
production year.
II. Improvements in the relative quality of the goods produced in the
currents year are not indicated in the GDP.
III. GDP/GNP does not show the income distribution in the economy, the
measurements simply indicate the total output.
 5.7. Inflation and unemployment
. Inflation
In a broad sense, inflation is defined as a sustained rise in the general level of prices. Two
points about this definition need emphasis. First, the increase price must be a sustained one, and
it is not simply a once for all increase in prices. Second, it must be the general level of prices,
which is rising; increase in individual prices, which can be offset by falling in prices of other
goods is not considered as inflation. Thus we define inflation rate (Πt) as:
Pt  Pt 1
Πt = x100
Pt 1
Where Pt is overall price index (CPI, GDP deflator) for time –t
Pt-1 is over all price index for time t-1
 Cause of inflation
 Theories that deal with the causes of inflation generally classified
into two major groups: Demand pull and cost push factors.
i. Demand pulls factors.
 According to demand pull theory of inflation, inflation is the
resulted from a rapid increase in demand for goods and services than
supply of goods and services (fixed level of goods and services
supplied).
II. Cost push (supply side) factors
 There are non-demand factors that cause inflation. Cost push
inflation occurs when different factors which increases cost of
production (increases price of input) and other structural bottle neck
cause firms to reduce the supply of goods and services below existing
demand
 Effects of inflation
1. Generally inflation reduces real money balance or purchasing
power of money.
2. Inflation increases uncertainties about macroeconomic policy
and adversely affects the public decision making ability.
3. Inflation is an indicator of the overall inability of government
to manage the economy.
4. Unanticipated inflation hurts individuals with fixed income
(pension).
5. The case of debtors and creditors: inflation is a friend of
debtors and an enemy of creditors.
.
 Unemployment
 Unemployment is a situation in which able bodied persons willing to work
at prevailing wage rate do not able to find job. People who are not in the
work force include
 Young people who are below some legally established age limit
 Full time students
 Retired people
 People who are hospitalized (i.e., only for the period in which they are
hospitalized)
 People held in prison and mental institutions
 Unemployment is measured by rate of unemployment, which represents
the percentage of those people who wants to work but cannot get any job.

Noofu
ne
mplo
ye
d
Unemployment rate = ( la
bo
rfo
rce
)1
00
 Types of unemployment
1. Frictional unemployment.
 The reason behind frictional unemployment is that it takes
time to match workers with jobs.
 Besides, the flow of information about job candidates and job
vacancies is imperfect. Geographical motilities of workers are
not instantaneous, in addition workers difference in
preference and jobs have different attributes.
 For all these reasons, searching for an appropriate job takes
time and effort. Such type of unemployment which created
due to
 The time to get job is known frictional unemployment.

2. Structural unemployment

 Structural unemployment arises due to structural change in dynamic

economy and wage rigidity.

 Such structural change includes change in the structure or sectoral

composition of the economy due to technological change.

 That is gradual decline of some kind of industries production and the

emergence of new industries.

 Some skills become obsolete and less efficient resulting mismatch

between labor demand and supply.

 The second reason for structural unemployment is wage rigidity.

Workers are unemployed sometimes not because of the skill gap at
ongoing wage rate but, the supply of labour exceeds the demand.
3. Seasonal unemployment: arises at least for two reasons

I. In the first case, industrial production slows down anticipating for

example seasonal weather changes.

II. In the second case, the concentration of graduating students at

the end of the year accounts for high number of unemployed
people.

4. Cyclic unemployment

 Cyclic unemployment is unemployment created associated with short

run fluctuation of the economy.

 Workers become unemployed for some period when job evaporates

due to recession and returns to job when there is expansion in
economic activities.

 It is avoidable type of unemployment, since a set of macroeconomic

policies geared towards promoting aggregate demand can avoid it.
 5. Natural rate of unemployment
 As we said, only cyclical unemployment is a direct result of the
economy’s weak performance. The other forms of
unemployment, however involve other variables outside of the
economy. Such a contention led economists to the conclusion
that at any point in time there may be some people in the work
force who remain unemployed even if the economy is
functioning without difficulty. This is what we mean by natural
rate of unemployment.
Mathematically,
 Natural rate of unemployment= No. of unemployed – No. of
cyclically unemployed
Total work force
= No of frictionally, seasonally,
and structurally unemployed
Total work force
Cost of unemployment
 Business cycle

 The ups and downs of the economy, in the short run

are known as business cycle.

 It is a regular pattern of expansion and contraction in

economic activity around trend growth.

 All industrialized societies are subject to recurrent

fluctuations in economic activity.

 Even though the fluctuation characterizes all macro

variables, in most case business cycle primarily represents
fluctuation of output or GDP along the trend.
 Peak or boom refers to the highest level of aggregate
output or GNP over a period of time.
 Peaks imply that at these points the economy performs
at or close to full capacity and that it opens up greater
job opportunities
 Recession are often result of over heated economy in
times of boom, too much activity, too much money chasing
increasingly too few goods lead to decline in GDP.
Business persons lose confidence, and cut production.
Unemployment rises and income falls, prices decline.
 The point in which a recession ends and recovery begins is
called a trough.

 Although employment and incomes are still too low, everybody

begins to rebuild hope believing that the economy cannot get
any worse.

 Recovery (expansion) is a prolonged journey.

 It is built on the revival of business confidence from which

everything else springs.

 In this phase, production, the number of jobs, incomes and

demand gradually increase.
 The line from the origin shows the trend growth, long run
change in the level of output over time when full
employment of resources is achieved.
 The deviation of output from the trend level (Output gap)
shows the change in level of employment of resources
from full employment level.
 Positive output gap shows over employment of resources
and utilization of improved method of production.