Macro Economics I Module

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Macro Economics-I Module
Introduction to Macroeconomics (Addis Ababa University)
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Table of Contents
UNIT ONE: OVERVIEW: DEFINITION, FOCUS AREAS AND INSTRUMENTS OF

MACROECONOMICS 1
SECTION ONE: DEFINITION AND FOCUS AREAS OF MACROECONOMICS 2
1.1 Definition of Macroeconomics 2
1.2 Focus areas of Macroeconomics 3
SECTION TWO: THE STATE OF MACROECONOMICS 4
2.1 Evolution and Recent Developments 5
2.2 The Classical and Neoclassical Macroeconomics School 6
2.3 The Keynesian Macroeconomics School 7
2.4 The New Classical Macroeconomics School 8
2.5 The New Keynesian Macroeconomics School 10
UNIT SUMMARY 12
UNIT TWO : NATIONAL INCOME ACCOUNTING 14
SECTION ONE: APPROACHES TO MEASURING GDP 15
1.1 The Value Added Approach 16
1.2 The Income Approach 17
1.3 The Expenditure Approach 18
1.4 Other Social Accounts (GNP, NNP, NI, PI and DI) 19
SECTION 3: REAL GDP VERSUS NOMINAL GDP 21
3.1 Nominal GDP 21
3.2 Real GDP 22
SECTION 4: THE CONSUMER PRICE INDEX AND GDP DEFLATOR 23
4.1 The Consumer Price Index 23
4.2 The GDP Deflator 24
4.3 The CPI versus the GDP Deflator 25
SECTION 5: GDP AND WELFARE 27
SECTION 6: THE BUSINESS CYCLE 28
6.1 Definition and Characteristics of Business Cycle 28
SECTION 7: INFLATION, UNEMPLOYMENT AND THE PHILIPS CURVE 30
7.1 Unemployment 30
7.2 Inflation 31
7.3 The Trade offs between Inflation and Unemployment- the Philips Curve 31
UNIT SUMMARY 33

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UNIT THREE: MACROECONOMIC FLUCTUATIONS: THE IS-LM APPROACH 36

SECTION ONE: MACROECONOMIC FLUCTUATIONS 37
1.1 Quantity-Adjustment versus Price-Adjustment Paradigms 37
1.2 The IS–LM Model 40
SECTION TWO: EXPLAINING FLUCTUATIONS WITH THE IS–LM MODEL 63
2.1 Changes in Fiscal Policy 64
2.2 Changes in Monetary Policy 66
2.3 The Interaction between Monetary and Fiscal Policies 67
UNIT SUMMARY 69
UNIT FOUR: AGGREGATE DEMAND AND AGGREGATE SUPPLY 73
SECTION ONE: AGGREGATE DEMAND 74
1.1 From the IS–LM Model to the AD Curve 75
1.2 Characterizing the Aggregate Demand Curve 76
SECTION TWO: AGGREGATE SUPPLY 81
2.1 Introduction to Aggregate Supply 81
2.2 Four Models of Aggregate Supply 84
2.3 Inflation, Unemployment, and the Phillips Curve 95
UNIT SUMMARY 107
UNIT FIVE: OPEN ECONOMY MACROECONOMICS 110
SECTION ONE: EXCHANGE RATES AND EXCHANGE RATE REGIMES 111
1.2 Nominal, Real and Effective Exchange Rates 112
1.3 Alternative Exchange Rate Regimes 113
SECTION 2: THE BALANCE OF PAYMENTS 115
2.1 Definition 115
2.2 An Overview of the Sub-Accounts in the Balance of Payments 116
SECTION 3: OPEN ECONOMY IDENTITIES AND MULTIPLIERS 119
3.1 Some Open Economy Identities 120
3.2 Open Economy Multipliers 121
3.3 The Marshall-Lerner Condition and the J-Curve Effect 126
SECTION 4: MACROECONOMIC POLICY IN AN OPEN ECONOMY: THE MUNDELL-
FLEMING MODEL 130
4.1 The IS-LM-BP Model 129
4.2 Factors Affecting the IS-LM-BP Schedule 136
4.3 A Small Open Economy with Perfect Capital Mobility 139
4.3 A Small Open Economy with Imperfect Capital Mobility 143
UNIT SUMMARY 149

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PREFACE
This module has five units. Unit one presents issues of concern in macroeconomics and
the major schools of macroeconomics and where their differences lie. Unit Two
discusses how we measure economic variables, such as aggregate income, the inflation
rate, and the unemployment rate. In Unit Three, we will study the IS–LM model, which is
the leading interpretation of Keynes’s theory. The model show what determines national
income for any given price level, and examines the behaviour of the economy when
prices are sticky. This non-market-clearing model is designed to analyze short-run
issues, such as the reasons for economic fluctuations and the influence of government
policy on those fluctuations. The fourth unit develops the model of aggregate demand
and aggregate supply. It then uses this model to show how shocks to the economy lead
to short-run fluctuations in output and employment. The fifth unit begins by developing
an open-economy version of the IS–LM model, called the Mundell–Fleming model. The
Mundell–Fleming model extends the short-run model of national income from Unit
Three by including the effects of international trade and finance.

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UNIT ONE
OVERVIEW: DEFINITION, FOCUS AREAS AND INSTRUMENTS
OF MACROECONOMICS
UNIT OBJECTIVES
After studying this chapter, students will be able to:

 Define the term macroeconomics
 Explain the focus areas of macroeconomics
propagation
 Differentiate between classical, new classical, Keynesian and new Keynesian
macroeconomics.
 Identify the reasons for the development of macroeconomics as a separate
subject.
 Discuss the difference between macroeconomics and microeconomics.
UNIT INTRODUCTION
Macroeconomics is concerned with the behavior 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 rates of inflation and unemployment, the balance of payments
and the exchange rates.
The difference between microeconomics and macroeconomics is primarily one of

emphasis and exposition. In studying price determination in a single industry, it is
convenient for microeconomics to assume that prices in other industries are given.
In macroeconomics, in which we study the average price level, it is for the most part
sensible to ignore changes in relative prices of goods among different industries. In
microeconomics, it is convenient to assume that the total income of all consumers
is given and then to ask how consumers divide their spending of that income among
different goods. In macroeconomics, by contrast, the aggregate level of income or
spending is among the key variables to be studied.
The most helpful circumstance for the rapid propagation of a new revolutionary

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theory is the existence of an established orthodoxy, which is clearly inconsistent

with the most salient facts of reality. The inability of the classical model to account
adequately for the collapse of output and employment in the 1930s paved the way
for the Keynesian revolution. During the 1950s and 1960s, the neoclassical synthesis
became the accepted wisdom for the majority of economists.
In this unit, we will first define macroeconomics and then briefly explain the focus
areas and objectives of macroeconomics. Later in the chapter, the major schools of
thoughts in macroeconomics are presented in detail.
PRE-TEST
 Define macroeconomics in your own words.
SECTION ONE: DEFINITION AND FOCUS AREAS OF

MACROECONOMICS
Section Objectives
After studying this section, students will be able to:

 define macroeconomics
 explain the focus areas of macroeconomics
1.2 Definition of Macroeconomics
Macroeconomics is concerned with the structure, performance and behavior of the

economy as a whole. It explains the overall level of a nations output, employment,
prices, and foreign trade. The prime concern of macroeconomists is to analyze and
attempt to understand the underlying determinants of the main aggregate trends in
the economy with respect to the total output of goods and services (GDP),

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unemployment, inflation and international transactions. In particular,

macroeconomic analysis seeks to explain the cause and impact of short-run
fluctuations in GDP (the business cycle), and the major determinants of the long-run
path of GDP (economic growth). Obviously the subject matter of macroeconomics is
of crucial importance because in one way or another macroeconomic events have an
important influence on the lives and welfare of all of us.
1.1 Focus areas of Macroeconomics
Macroeconomics focuses on the economic behavior and policies that affect

consumption and investment, the dollar and the trade balance, the determinants of
changes in wages and prices, monetary and fiscal policies, the money stock the
federal budget, the interest rates and the national debt.
In brief, macroeconomics deals with the major economic issues and problems of the
day. To understand these issues, we have to reduce the complicated details of the
economy to manageable essentials. Those essentials lay in the interactions among
the goods, labor and asset markets of the economy, and in the interactions among
the national economies whose residents trade with each other.
In macroeconomics we deal with the market for goods as a whole, treating all the
markets for different goods as a single market. Similarly, we deal with the labor
market and the asset market as a whole. The benefit of abstracting is increased
understanding of the vital interactions among the goods, labor, and assets markets.
The cost of abstraction is that omitted details sometimes matter.
It is difficult to overstate just how important satisfactory macroeconomic

performance is for the well-being of the citizens of any country. An economy that
has successful macroeconomic management should experience low unemployment
and inflation, and steady and sustained economic growth. In contrast, in a country
where there is macroeconomic mismanagement, we will observe an adverse impact
on the living standards and employment opportunities of the citizens of that country.
In extreme circumstances, the consequences of macroeconomic instability have
been devastating. For example, the catastrophic political and economic
consequences of failing to maintain macroeconomic stability among the major

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industrial nations during the period 1918–33 ignited a chain of events that
contributed to the outbreak of the Second World War, with disastrous consequences
for both humanity and the world economy .Macroeconomics deals with such major
issues
 Economic growth
 Inflation
 Unemployment
 Foreign trade
Based on those problems the objectives of macroeconomics are:
 Generating a high level of production of economic goods and services
for the population.
 High employment - providing jobs
 A stable or gently rising level of price level with prices and wages are
determined by free markets.
 Foreign economic relations marked by a stable foreign exchange rate
and export more or less balancing imports.
Section reflection/review
 What are the objectives of macroeconomics?

 What is macroeconomics?
 What is the difference between macroeconomics and microeconomics?
PRE-TEST
 What factors do you think contribute to the development of
macroeconomics?
SECTION TWO: THE STATE OF MACROECONOMICS
Section Objectives
After studying this section, students will be able to:

 Compare and contrast the different macroeconomics schools.

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Section Overview
SECTION TWO: THE STATE OF

MACROECONOMICS
2.1 Evolution and Recent Developments
2.2 The Classical and Neoclassical

Macroeconomics School
2.3 The Keynesian Macroeconomics School
2.4 The New Classical Macroeconomics School
2.5 The New Keynesian Macroeconomics

School
2.1 Evolution and Recent Developments
The Great Depression gave birth to modern macroeconomics as surely as

accelerating inflation in the late 1960s and early 1970s facilitated the monetarist
counter-revolution. It is also important to note that many of the most famous
economists of the twentieth century, such as Milton Friedman, James Tobin and
Paul Samuelson, were inspired to study economics in the first place as a direct result
of their personal experiences during this period.
While Laidler has reminded us that there is an extensive literature analyzing the
causes and consequences of economic fluctuations and monetary instability prior to

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the 1930s, the story of modern macroeconomics undoubtedly begins with the Great
Depression. Before 1936, macroeconomics consisted of an ‘intellectual witch’s brew:
many ingredients, some of them exotic, many insights, but also a great deal of
confusion. For more than 70 years, economists have attempted to provide a
coherent explanation of how the world economy suffered such a catastrophe.
Although it is important to remember that economists before Keynes discussed

what we now call macroeconomic issues such as business cycles, inflation,
unemployment and growth, as we have already noted, the birth of modern
macroeconomics as a coherent and systematic approach to aggregate economic
phenomena can be traced back to the publication in February 1936 of Keynes’s book
The General Theory of Employment, Interest and Money.
2.2 The Classical and Neoclassical Macroeconomics School
Classical economics is that body of thought, which existed prior to the publication of
Keynes’s, General Theory. For Keynes the classical school not only included Adam
Smith, David Ricardo and John Stuart Mill, but also ‘the followers of Ricardo. Keynes
was therefore at odds with the conventional history of economic thought
classification, particularly with his inclusion of both Alfred Marshall and Arthur Cecil
Pigou within the classical school. However, given that most of the theoretical
advances, which distinguish the neoclassical from the classical period, had been in
microeconomic analysis, Keynes perhaps felt justified in regarding the
macroeconomic ideas of the 1776–1936 period, such as they existed, as being
reasonably homogeneous in terms of their broad message. This placed great faith in
the natural market adjustment mechanisms as a means of maintaining full
employment equilibrium.
Before moving on to examine the main strands of macroeconomic thought
associated with the classical economists, the reader should be aware that, prior to
the publication of the General Theory, there was no single unified or formalized
theory of aggregate employment, and substantial differences existed between
economists on the nature and origin of the business cycle .The structure of classical
macroeconomics mainly emerge after 1936 and did so largely in response to
Keynes’s own theory in order that comparisons could be made.
Classical economists were well aware that a capitalist market economy could

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deviate from its equilibrium level of output and employment. However, they believed
that such disturbances would be temporary and very short-lived. Their collective view
was that the market mechanism would operate relatively quickly and efficiently to
restore full employment equilibrium. If the classical economic analysis was correct,
then government intervention, in the form of activist stabilization policies, would be
neither necessary nor desirable. Indeed, such policies were more than likely to create
greater instability.
It follows that the classical writers gave little attention to either the factors, which
determine aggregate demand, or the policies, which could be used to stabilize
aggregate demand in order to promote full employment. For the classical
economists full employment was the normal state of affairs. But how did the
classical economists reach such an optimistic conclusion? In what follows we will
present a ‘stylized’ version of the classical model which seeks to explain the
determinants of an economy’s level of real output ( Y), real wage (W/P) and nominal
(W) wages, the price level (P) and the real rate of interest (r) In this stylized model it
is assumed that:
1. All economic agents (firms and households) are rational and aim to maximize
their profits or utility; furthermore, they do not suffer from money illusion;
2. All markets are perfectly competitive, so that agents decide how much to buy and
sell based on a given set of prices, which are perfectly flexible;
3. All agents have perfect knowledge of market conditions and prices before
engaging in trade
4. Trade only takes place when market-clearing prices have been established in all
markets
5. Agents have stable expectations.
These assumptions ensure that in the classical model, markets, including the labor
market, always clear.
2.3 The Keynesian Macroeconomics School
For the early post-war years, the central distinguishing beliefs within the orthodox
Keynesian school can be listed as follows:

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 The economy is inherently unstable and is subject to erratic shocks. These

shocks are attributed primarily to changes in the marginal efficiency of
investment following a change in the state of business confidence, or what
Keynes referred to as a change in investors’ ‘animal spirits’.
 Left to its own devices the economy can take a long time to return to the
neighborhood of full employment after being subjected to some disturbance;
that is, the economy is not rapidly self-equilibrating.
 The aggregate level of output and employment is essentially determined by
aggregate demand and the authorities can intervene to influence the level of
aggregate ‘effective’ demand to ensure a more rapid return to full
employment.
 In the conduct of stabilization policy, fiscal as opposed to monetary policy is
generally preferred as the effects of fiscal policy measures are considered to
be more direct, predictable and faster acting on aggregate demand than
those of monetary policy. These beliefs found expression in the orthodox
Keynesian model, known as the IS–LM model.
In the General Theory Keynes sets out to ‘discover what determines at any time the
national income of a given system and the amount of its employment. In the
framework he constructs, the national income depends on the volume of
employment. In developing his theory, Keynes also attempted to show that
macroeconomic equilibrium is consistent with involuntary unemployment. The
theoretical novelty and central proposition of the book is the principle of effective
demand, together with the equilibrating role of changes in output rather than prices.
The emphasis given to quantity rather than price adjustment in the General Theory is
in sharp contrast to the classical model, where discrepancies between saving and
investment decisions cause the price level to oscillate.
2.4 The New Classical Macroeconomics School
During the early 1970s, there was a significant renaissance of the belief that a
market economy is capable of achieving macroeconomic stability, providing that the
visible hand of government is prevented from conducting misguided discretionary
fiscal and monetary policies. In particular the ‘Great Inflation’ of the 1970s provided
increasing credibility and influence to those economists who had warned that

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Keynesian activism was both over ambitious and, more importantly, predicated on
theories that were fundamentally flawed.
To the Keynesian critics the events of the Great Depression together with Keynes’s
theoretical contribution had mistakenly left the world ‘deeply skeptical about self
organizing market systems.’ The orthodox Keynesian insistence that relatively low
levels of unemployment are achievable via the use of expansionary aggregate
demand policies was vigorously challenged by Milton Friedman, who launched a
monetarist ‘counter-revolution’ against policy activism during the 1950s and 1960s.
During the 1970s, another group of economists provided a much more damaging
critique of Keynesian economics. Their main argument against Keynes and the
Keynesians was that they had failed to explore the full implications of endogenously
formed expectations on the behavior of economic agents. Moreover, these critics
insisted that the only acceptable way to incorporate expectations into
macroeconomic models was to adopt some variant of John Muth’s (1961) ‘rational
expectations hypothesis.’ Following Thomas Sargent’s (1979) contribution, rational
expectationists, who also adhered to the principle of equilibrium theorizing, became
known collectively as the new classical school. As the label infers, the new classical
school has sought to restore classical modes of equilibrium analysis by assuming
continuous market clearing within a framework of competitive markets.
The assumption of market clearing, which implies perfectly and instantaneously

flexible prices, represents the most controversial aspect of new classical theorizing.
The incorporation of this assumption represents the classical element in their
thinking, namely a firm conviction ‘that the economy should be modeled as an
economic equilibrium’. Thus, to new classical theorists, ‘the ultimate
macroeconomics is a fully specified general equilibrium microeconomics.’ This
approach implies not only the revival of classical modes of thought but also ‘the
euthanasia of macroeconomics.’
This school of macroeconomics, which includes among its leaders Robert Lucas,
Thomas Sargent, Robert Barro, and Edward Prescott and Neil Wallace of the
University of Minnesota, shares many policy views with Freidman. 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

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things worse by intervening. Their approach is a challenge to traditional

macroeconomics, which sees a role for useful government action in an economy
that is viewed as adjusting sluggishly, with slowly responding prices, poor
information, and social customs impeding the rapid clearing of markets.
The central working assumptions of the new classical school are three:
1. Economic agents maximize. Households and firms make optimal decisions.
This means that they use all available information in reaching decisions and
that those decisions are the best possible in the circumstances in which they
find themselves.
2. Expectations are rational, which means they are statistically the best
predictions of the future that can be made using the available information.
indeed, the new classical school is sometimes described as the rational
expectations school, even though rational expectations is the only one part of
the theoretical approach of the new classical economists. Rational
expectations imply that people will eventually come to understand whatever
government policy is being used, and thus that it is not possible to fool most
of the people all the time or even most of the time.
3. Markets clear. There is no reason why firms or workers would not adjust
wages and prices if that would make them better off. Accordingly, prices and
wages adjust in order to equate supply and demand; in other words, markets
clear.
One dramatic implication of these assumptions, which seem so reasonable

individually, is that there is no possibility for involuntary unemployment. Any
unemployed person who really wants a job will offer to cut his or her wage until the
wage is low enough to attract an offer from some employer. Similarly, anyone with
an excess supply of goods on the shelf will cut prices so as to sell. Flexible
adjustment of wages and prices leaves all individuals all the time in a situation in
which they work as much as they want and firms produce as much as they want.
The essence of the new classical approach is the assumption that markets are
continuously in equilibrium. In particular, new classical macroeconomics regard as
incomplete or unsatisfactory any theory that leaves open the possibility that private
individuals could make themselves better off by trading among themselves.
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2.5 The New Keynesian Macroeconomics School
During the 1980s, there was a growth of interest in the early Keynes in order to better
understand the later Keynes of the General Theory. There is an increasing
recognition and acceptance that Keynes’s philosophical and methodological
framework had a significant influence upon his economic analysis as well as his
politics. Whilst much has been written about the alleged content of Keynes’s
economics, very little has dealt with Keynes’s method and philosophy. The great
stimulus to macroeconomic theory provided by Keynes is well recognized but much
less is said about his views on scientific methodology, ‘Keynes’s methodological
contribution has been neglected generally. The only major exception to the change
was the latter’s earlier study, which endeavored to provide a serious extended
analysis of the connection between Keynes’s philosophy and his economics. The
more recent attempts to explore the methodological and philosophical foundations
of Keynes’s political economy have been termed ‘the new Keynes scholarship.’
The main aim of the new scholarship is to highlight the need to recognize that
Keynes’s economics has a strong philosophical base and to provide a detailed
examination of Keynes’s rich and elaborate treatment of uncertainty, knowledge,
ignorance and probability. The new scholarship also gives prime importance to
Keynes’s lifelong fascination with the problem of decision making under conditions
of uncertainty.
The new classical school 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. the
group includes among others George Akerlof and Janet Yallen and David Romer of
the University of California- Berkeley, Olivier Blanchard of MIT, Greg Mankiw and
Larry Summers of Harvard, and Ben Bernanke of Princeton university. They do not
believe that markets clear all the time but seek to understand and explain exactly
why markets can fail.
The new Keynesian argues that markets sometimes do not clear even when
individuals are looking out for their own interests. Both information problem and
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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 also are also likely
to wind up with a poorer quality labor force. Thus, they will be reluctant to cut wages.
If it is costly for firms to change the prices they charge and the wages, they pay, the
changes will be infrequent; but if all firms adjust prices and wages infrequently, the
economy wide level of wages and prices may not be flexible enough to avoid
occasional periods of even high unemployment.
Section reflection/ review
 What is classical and neoclassical macroeconomics?

 Is new Keynesian macroeconomics school different from the orthodox
Keynesian school? If so, how?
 What is the essence of new classical macroeconomics school?
 What are the central working assumptions of new classical
macroeconomics?
UNIT SUMMARY
1. Macroeconomics is the study of the economy as whole-including GDP growth,

unemployment, inflation, and exchange rate.
2. The great depression of the 1930’s is the major historical factor that
contributes for the development of macroeconomics as a separate discipline.
3. The classical economists believe that the market mechanism would operate
relatively quickly and efficiently to restore full employment equilibrium, so
that there is no room for government intervention to regulate the market.
4. Unlike the classical and neoclassical economists, the Keynesians argued that
the economy is inherently unstable so that aggregate demand is affected.
They proposed stabilization policies to correct this problem. It is suggested
that fiscal policy is preferred to monetary policy.
5. According to the new classical macroeconomists, Economic agents are
rational and make optimal decision. Markets are expected to clear
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continuously
6. The new Keynesian argues that markets sometimes do not clear even when
individuals are looking out for their own interests. Both information problem
and costs of changing prices lead to some price rigidities, which help cause
macroeconomic fluctuations in output and employment.
POST-TEST
Discuss the following questions

What is macroeconomics?
1. What are the objectives of macroeconomics?
2. Distinguish between microeconomics and macroeconomics.
3. Compare and contrast the Keynesian and new Keynesian macroeconomics
school.
4. What are the basic assumptions of classical and new classical
macroeconomics schools? Discuss the difference and similarities of these
schools.
5. Which one of the school of thoughts discussed above do you support? Why?
Support your answer with evidence.
6. Do you think that new classical economics is different from the classical
economists? Why?
7. What is the difference between classical and Keynesian macroeconomics?
8. What are the basic tenets of classical macroeconomics school? Discuss
briefly
REFERENCE
Snowdon B, Vane H. R. (2005), Modern Macroeconomics Its Origins, Development

and Current State, Edward Elgar Publishing Limited, UK.
Mankiw G, (2004)Macroeconomics,5th ed,
Dornbusch R, and Fischer S.,(2002) Macroeconomics,6th ed,
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UNIT TWO
NATIONAL INCOME ACCOUNTING
UNIT OBJECTIVES
After the end of this lesson, the students will be able to:
 Differentiate between the different approaches of measuring GDP.
 Explain the different types of inflation and unemployment.
 Distinguish between real and nominal GDP.
 Explain business cycle.
 Distinguish between GDP deflator and consumer price index.
 Explain the problem of measuring GDP.
UNIT INTRODUCTION
National income accounting refers to a set of rules and techniques that are used to
measure the national income of a country. National income is a measure of the value of
goods and goods produced by the residents of an economy in a given period of time,
usually a quarter or a year.
National income can be real or nominal. Nominal national income refers to the current
year production of goods and services valued at current year prices. Real national
income refers to the current year production of goods and service valued at base year
prices.
In estimating national income, only productive activities are included in the computation
of national income. In addition, only the values of goods and services produced in the
current year are included in the computation of national income. Hence, gains from
resale are excluded but the services provided by the agents are counted. Similarly,
transfer payments are excluded as there is income received but no good or service
produced in return. However, not all goods and services from productive activities enter
into market transactions. Hence, imputations are made for these non-marketed but
productive activities e.g. imputed rental for owner-occupied housing. Thus, national
income refers to the market value or imputed value of additional goods and services
produced and services performed in the current period.
National income in many countries is in either Gross Domestic Product (GDP) or Gross
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National Product (GNP).
Gross Domestic product (GDP) refers to the total value of goods and services produced
within the geographical boundary of a country before the deduction of capital
consumption. Net Domestic product (NPD) refers to the total value of goods and
services produced within the geographical boundary of a country after the deduction of
capital consumption.
Gross National Product (GNP) refers to the total value of goods and services produced
by productive factors owned by residents of the country both inside and outside of the
country before the deduction of capital consumption. Net National Product (NNP))
refers to the total value of goods and services produced by productive factors owned by
residents of the country both inside and outside of the country after the deduction of
capital consumption.
Relationship between GDP and GNP
GNP = GDP + NPIFA (Net Property Income from Abroad)
Net Property Income from abroad refers to the difference between income from abroad
and income to abroad.
In this unit, we will discuss different approaches of measuring GDP, the difference
between real GDP and nominal GDP. In addition to this, brief introduction of inflation,
unemployment, Consumer price index, GDP deflator, and Business cycle are presented.
PRE-TEST
 Assume you are asked to calculate the total output of Ethiopia. How do you
measure the total output?
SECTION ONE: APPROACHES TO MEASURING GDP
Section Objectives
After the end of this section, students will be able to:

 Calculate GDP using the value added, the income and expenditure approaches.
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Section Overview
SECTION ONE: APPROACHES TO

MEASURING GDP
1.1 The Value Added Approach
1.2 The Income Approach
1.3 The Expenditure Approach
1.4 Other Social Accounts (GNP, NNP, NI, PI

and DI)
In this section, the approaches to measuring GDP are included. We will discuss the ways
of measuring GDP following different approaches. There are three approaches to
measuring GDP.
 Product or value added approach
 Expenditure approach
 Income approach
Each approach gives a different perspective on the economy. However, the fundamental
principle underlying national income accounting is that, except for problems such as
incomplete or misreported data, all three approaches give identical measurements of
the amount of current economic activity
1.1 The Value Added Approach
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The product approach measures economic activity by adding the market values of
goods and services produced, excluding any goods and services used up in intermediate
stages of production. This approach makes use of the value-added concept. The value
added of any producer is the value of its output minus the value of the inputs it
purchases from other producers. The product approach computes economic activity by
summing the values added by all producers.
Value added refers to the difference between the value of gross output of all goods and
services produced in a given period and the value of intermediate inputs used in the
production process during the same period.
Example
Stage of production Sales receipts Value added
Wheat 24 24
Flour 33 9
Baked dough 60 27
Bread 90 30
Total 207 90
1.2 The Income Approach
The income approach to GDP consists of the payments in terms of money to the factors
of production annually in a country. Thus GDP is the sum total of the following items.
 Compensation of employees (W, S): this is the income from the sale of labor
service during the year. It includes wages, salaries, and fringe benefits such as
employer provided insurance and employer contribution to pension funds.
 Rental income(R): is earned by those who supply the service of land, mineral
rights, and building for use by others.
 Interest (I) - comprises items such as the interest payments households receive
on saving deposits, certificate deposits, and corporate bonds.
 Proprietor’s income (Πp): is net income of sole proprietorships and partnerships.
 Corporate profit (Πc): include dividends, undistributed profits, and corporate
profit taxes.
 Indirect business taxes (IBT): taxes levied on sales of final products by business
firms that increase the cost of these firms and are therefore reflected in the
market value of goods and services sold. Example: sales tax, excise tax, business
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property tax, license fee.

 Capital consumption allowance ( depreciation) D
GDP= (W+S) +R+I+Π+D+IBT, where Π= Πc+ Πp
1.3 The Expenditure Approach
It only includes expenditure on goods and services to satisfy the needs of final buyers. It
excludes expenditure on intermediate of goods and services. Moreover, resale of
consumer and capital goods are excluded because the expenditures are on these resale
goods, not goods produced in the current period and hence expenditures on resale
goods are not counted.
Economists and policymakers care not only about the economy’s total output of goods
and services but also about the allocation of this output among other uses. The national
income accounts divide GDP into four broad categories of spending:
 Consumption (C)
 Investment (I)
 Government purchases (G)
 Net exports (NX).
Thus, letting Y stand for GDP,
Y =C +I +G+ NX.
GDP is the sum of consumption, investment, government purchases, and net ex-ports.
Each dollar of GDP falls into one of these categories. This equation is an identity, an
equation that must hold because of the way the variables are defined. It is called the
national income accounts identity.
Consumption consists of the goods and services bought by households. It is divided into
three subcategories: nondurable goods, durable goods, and services. Nondurable goods
are goods that last only a short time, such as food and clothing. Durable goods are
goods that last a long time, such as cars and TVs. Services include the work done for
consumers by individuals and firms, such as haircuts and doctor visits.
Investment consists of goods bought for future use. Investment is also divided into
three subcategories: business fixed investment, residential fixed investment, and
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inventory investment. Business fixed investment is the purchase of new plant and
equipment by firms. Residential investment is the purchase of new housing by
households and landlords. Inventory investment is the increase in firms’ inventories of
goods (if inventories are falling, inventory investment is negative).
Government purchases are the goods and services bought by federal, state, and local
governments. This category includes such items as military equipment, highways, and
the services that government workers provide. It does not include transfer payments to
individuals, such as Social Security and welfare. Because transfer payments reallocate
existing income and are not made in exchange for goods and services, they are not part
of GDP.
Net exports: takes into account trade with other countries. Net exports are the value of
goods and services exported to other countries minus the value of goods and services
that foreigners provide us. Net exports represent the net expenditure from abroad on our
goods and services, which provides income for domestic producers.
1.4 Other Social Accounts (GNP, NNP, NI, PI and DI)
The national income accounts include other measures of income that differ slightly in
definition from GDP. To see how the alternative measures of income relate to one
another, we start with GDP and add or subtract various quantities. To obtain gross
national product (GNP), we add receipts of factor income (wages, profit, and rent) from
the rest of the world and subtract payments of factor income to the rest of the world:
GNP=GDP+ Factor Payments from abroad-Factor Payments to Abroad.
Whereas GDP measures the total income produced domestically, GNP measures the
total income earned by nationals (residents of a nation). For instance, if Japanese
resident owns an apartment building in Addis Ababa, the rental income he earns is part
of Ethiopian GDP because it is earned in the Ethiopia. However, because this rental
income is a factor payment to abroad, it is not part of Ethiopian GNP.
To obtain net national product (NNP), we subtract the depreciation of capital-the amount
of the economy’s stock of plants, equipment, and residential structures that wears out
during the year:
NNP =GNP-Depreciation.
In the national income accounts, depreciation is called the consumption of fixed capital.
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Because the depreciation of capital is a cost of producing the output of the economy,
subtracting depreciation shows the net result of economic activity.
The next adjustment in the national income accounts is for indirect business taxes, such
as sales taxes. These taxes place a wedge between the price that consumers pay for a
good and the price that firms receive. Because firms never receive this tax wedge, it is
not part of their income. Once we subtract indirect business taxes from NNP, we obtain
a measure called national income:
National income= NNP-Indirect Business Taxes
National income measures how much everyone in the economy has earned. The national
income accounts divide national income into five components, depending on the way
the income is earned. The five categories are:
 Compensation of employees: The wages and fringe benefits earned by
workers.
 Proprietors' income: The income of non-corporate businesses, such as small
farms, and law partnerships.
 Rental income: The income that landlords receive, including the imputed rent
that homeowners “pay’’ to themselves, less expenses, such as depreciation.
 Corporate profits: The income of corporations after payments to their
workers and creditors.
 Net interest: The interest domestic businesses pay minus the interest they
receive, plus interest earned from foreigners.
A series of adjustments takes us from national income to personal income, the amount
of income that households and non-corporate businesses receive. Three of these
adjustments are most important. First, we reduce national income by the amount that
corporations earn but do not pay out, either because the corporations are retaining
earnings or because they are paying taxes to the government. This adjustment is made
by subtracting corporate profits (which equals the sum of corporate taxes, dividends,
and retained earnings) and adding back dividends. Second, we increase national income
by the net amount the government pays out in transfer payments. This adjustment
equals government transfers to individuals minus social insurance contributions paid to
the government. Third, we adjust national income to include the interest that households
earn rather than the interest that businesses pay. This adjustment is made by adding
personal interest income and subtracting net interest. (The difference between personal
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interest and net interest arises in part from the interest on the government debt.) Thus,
personal income is
Personal Income = National Income
-Corporate Profits
-Social Insurance Contributions
-Net Interest
+Dividends
+Government Transfers to Individuals
+Personal Interest Income.
Next, if we subtract personal tax payments and certain non-tax payments to the
government (such as parking tickets), we obtain disposable personal income:
Disposable Personal Income=Personal Income-Personal Tax and Non-tax

Payments.
We are interested in disposable personal income because it is the amount households
and non-corporate businesses have available to spend after satisfying their tax
obligations to the government.
 What is disposable income?
 What is the difference between National income and personal income?
 What is the difference between GDP, NNP, and NI?
 How do we measure GDP using the expenditure approach? What are its
components in this approach? Discuss briefly.
PRE-TEST
 Differentiate between real GDP and nominal GDP?
SECTION 3: REAL GDP VERSUS NOMINAL GDP
Section Objectives
At the end of this section, students will be able to:

 Compare and contrast real and nominal GDP.
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Section Overview
SECTION 3: REAL GDP VERSUS NOMINAL GDP
3.1Nominal GDP
3.2 Real GDP
Nominal GDP
Consider once again the economy that produces only apples and oranges. In this
economy GDP is the sum of the value of all the apples produced and the value of all the
oranges produced. That is,
GDP = (Price of Apples ×Quantity of Apples) + (Price of Oranges×
Quantity of Oranges).
Notice that GDP can increase either because prices rise or because quantities rise. It is
easy to see that GDP computed this way is not a good gauge of economic well-being.
That is, this measure does not accurately reflect how well the economy can satisfy the
demands of households, firms, and the government. If all prices doubled without any
change in quantities, GDP would double. Yet it would be misleading to say that the
economy’s ability to satisfy demands has doubled, because the quantity of every good
produced remains the same. Economists call the value of goods and services measured
at current prices nominal GDP.
3.2 Real GDP
A better measure of economic well-being would tally the economy’s output of goods and
services and would not be influenced by changes in prices. For this purpose, economists
use real GDP, which is the value of goods and services measured using a constant set of
prices. That is, real GDP shows what would have happened to expenditure on output if
quantities had changed but prices had not. To see how real GDP is computed, imagine
we wanted to compare output in 2002 and output in 2003 in our apple-and-orange
economy. We could begin by choosing a set of prices, called base-year prices, such as
the prices that prevailed in 2002.Goods and services are then added up using these base
-year prices to value the different goods in both years. Real GDP for 2002 would be
Real GDP = (2002 Price of Apples ×2002 Quantity of Apples) + (2002 Price of
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Oranges 2002 Quantity of Oranges).

Similarly, real GDP in 2003 would be
Real GDP= (2002 Price of Apples 2003 Quantity of Apples) + (2002
Price of Oranges 2003 Quantity of Oranges).
And real GDP in 2004 would be:

Real GDP= (2002 Price of Apples ×2004 Quantity of Apples) + (2002 Price
of Oranges ×2004 Quantity of Oranges).
Notice that 2002 prices are used to compute real GDP for all three years. Because the
prices are held constant, real GDP varies from year to year only if the quantities
produced vary. Because a society’s ability to provide economic satisfaction for its
members ultimately depends on the quantities of goods and services produced, real
GDP provides a better measure of economic well-being than nominal GDP.
 What is real GDP?
 Distinguish between real GDP and nominal GDP?
PRE-TEST
 What is the difference between CPI and GDP deflator?
SECTION 4: THE CONSUMER PRICE INDEX AND GDP DEFLATOR
Section Objectives

 Distinguish between GDP deflator and consumer price index
Section Overview
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SECTION 4: THE CONSUMER PRICE INDEX

AND GDP DEFLATOR
4.1 The Consumer Price Index
4.2 The GDP Deflator
4.3 The CPI versus the GDP Deflator
4.1 The Consumer Price Index
A dollar today does not buy as much as it did 20 years ago. The cost of almost
everything has gone up. This increase in the overall level of prices is called inflation, and
it is one of the primary concerns of economists and policymakers Here we discuss how
economists measure changes in the cost of living.
The most commonly used measure of the level of prices is the consumer price index
(CPI).The central statistical Agency, has the job of computing the CPI. It begins by
collecting the prices of thousands of goods and services. Just as GDP turns the
quantities of many goods and services into a single number measuring the value of
production, the CPI turns the prices of many goods and services into a single index
measuring the overall level of prices. How should economists aggregate the many
prices in the economy into a single index that reliably measures the price level? They
could simply compute an average of all prices. Yet this approach would treat all goods
and services equally. Because people buy more chicken than caviar, the price of chicken
should have a greater weight in the CPI than the price of caviar. The CSA weights
different items by computing the price of a basket of goods and services purchased by a
typical consumer. The CPI is the price of this basket of goods and services relative to
the price of the same basket in some base year. For example, suppose that the typical
consumer buys 5 apples and 2 oranges every month. Then the basket of goods consists
of 5 apples and 2 oranges, and the CPI is
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In this CPI, 2002 is the base year. The index tells us how much it costs now to buy 5
apples and 2 oranges relative to how much it cost to buy the same basket of fruit in
2002. The consumer price index is the most closely watched index of prices, but it is not
the only such index. Another is the producer price index, which measures the price of a
typical basket of goods bought by firms rather than consumers. In addition to these
overall price indices, the CSA computes price indices for specific types of goods, such
as food, housing, and energy.
4.2 The GDP Deflator
From nominal GDP and real GDP we can compute a third statistic: the GDP deflator. The
GDP deflator, also called the implicit price deflator for GDP, is defined as the ratio of
nominal GDP to real GDP:
The GDP deflator reflects what is happening to the overall level of prices in the economy.
To better understand this, consider again an economy with only one good, bread. If P is
the price of bread and Q is the quantity sold, then nominal GDP is the total number of
dollars spent on bread in that year, P Q. Real GDP is the number of loaves of bread
produced in that year times the price of bread in some base year, . The GDP
deflator is the price of bread in that year relative to the price of bread in the base year,.
The definition of the GDP deflator allows us to separate nominal GDP into two parts: one
part measures quantities (real GDP) and the other measures prices (the GDP
deflator).That is,
Nominal GDP=Real GDP × GDP Deflator.
Nominal GDP measures the current dollar value of the output of the economy. Real GDP
measures output valued at constant prices. The GDP deflator measures the price of
output relative to its price in the base year. We can also write this equation as
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In this form, you can see how the deflator earns its name: it is used to deflate
(That is, take inflation out of) nominal GDP to yield real GDP.
4.3 The CPI versus the GDP Deflator
The GDP deflator and the CPI give somewhat different information about what is
happening to the overall level of prices in the economy.
There are three key differences between the two measures.
 The first difference is that the GDP deflator measures the prices of all goods and
services produced, whereas the CPI measures the prices of only the goods and
services bought by consumers. Thus, an increase in the price of goods bought by
firms or the government will show up in the GDP deflator but not in the CPI.
 The second difference is that the GDP deflator includes only those goods
produced domestically. Imported goods are not part of GDP and do not show up
in the GDP deflator. Hence, an increase in the price of a Toyota made in Japan
and sold in this country affects the CPI, because the Toyota is bought by
consumers, but it does not affect the GDP deflator.
 The third and most subtle difference results from the way the two measures
aggregate the many prices in the economy. The CPI assigns fixed weights to the
prices of different goods, whereas the GDP deflator assigns changing weights. In
other words, the CPI is computed using a fixed basket of goods, whereas the
GDP deflator allows the basket of goods to change over time as the composition
of GDP changes. The following example shows how these approaches differ.
Suppose that major frosts destroy the nation’s orange crop. The quantity of
oranges produced falls to zero, and the price of the few oranges that remain on
grocers’ shelves is driven sky-high. Because oranges are no longer part of GDP,
the increase in the price of oranges does not show up in the GDP deflator. But
because the CPI is computed with a fixed basket of goods that includes oranges,
the increase in the price of oranges causes a substantial rise in the CPI.
Economists call a price index with a fixed basket of goods a Laspeyres index and a price
index with a changing basket a Paasche index. Economic theorists have studied the
properties of these different types of price indices to determine which a better measure
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of the cost of living is. The answer, it turns out, is that neither is clearly superior. When
prices of different goods are changing by different amounts, a Laspeyres (fixed basket)
index tends to overstate the increase in the cost of living because it does not take into
account that consumers have the opportunity to substitute less expensive goods for
more expensive ones. By contrast, a Paasche (changing basket) index tends to
understate the increase in the cost of living. Although it accounts for the substitution of
alternative goods, it does not reflect the reduction in consumers’ welfare that may result
from such substitutions.
The example of the destroyed orange crop shows the problems with Laspeyres and
Paasche price indices. Because the CPI is a Laspeyres index, it overstates the impact of
the increase in orange prices on consumers: by using a fixed basket of goods, it ignores
consumers’ ability to substitute apples for oranges. By contrast, because the GDP
deflator is a Paasche index, it understates the impact on consumers: the GDP deflator
shows no rise in prices, yet surely, the higher price of oranges makes consumers worse
off. Luckily, the difference between the GDP deflator and the CPI is usually not large in
practice.
 What is CPI?
 What is the difference between CPI and GDP deflator?
 How do we calculate CPI and GDP deflator?
PRE-TEST
 Do you think GDP is a good indicator of welfare? Why?
SECTION 5: GDP AND WELFARE
Section objectives
At the end of this section, students are able to:

 Explain the weakness of GDP as a measure of welfare.
Section overview
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GDP is a reasonably accurate and extremely useful measure of national economic

performance. It is not, and was never intended to be, an index of social welfare.
There are important items affecting our wellbeing that are not included in GDP.
 Non-market production- many useful services are produced by members of

households for the benefit of themselves or their families. But, GDP as a measure
of market value of output fails to include these productive transactions. It
significantly undervalues the total output of the nation by excluding non-market
household’s production.
 The value of leisure: the satisfaction you get from recreational activities and
other use of your leisure time also escapes inclusion in GDP.
 Improved product quality: GDP is a quantitative rather than a qualitative measure.

It does not accurately reflect improvements in the quality of products. Quality
improvement obviously affects economic well-being.
 The composition and distribution of output: changes in the composition and the
allocation of total output among specific households may influence economic
welfare. GDP, however, reflects only the size of output and does not tell us
anything about whether this allocation of goods is right for the society.
 Cost of environmental damage: The costs of environmental damage are not

subtracted from the market value of final products when GDP is calculated. It
over estimates the value of output.
 The under ground economy: this economy consists of transactions that never
reported to tax and other government authorities. It includes illegal goods and
services- narcotics trading, gambling, and prostitution. It also includes
participants in legal activities, which do not report their income to the revenue
authority. Example: waitress.
 What are the important items that are not included in GDP that affects welfare?
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PRE-TEST
 Define business cycle
SECTION 6: THE BUSINESS CYCLE
Section Objectives
At the end of this section, students are able to:

 Explain the characteristics of different components of business cycle
Section Overview
In this section, we will discuss the characteristics of business cycle.
6.1 Definition and Characteristics of Business Cycle
Business cycle refers to the recurrent up and downs in the level of economic activity that
extends over a period of several years. The economy cycles continuously between
growth and contraction. Some periods of growth are greater than others, and some
periods of contraction are deeper than the others are. Peaks, troughs and periods of
contraction or expansion characterize the business cycle.
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Potential output
Output
Peak Recovery
Trough
Recession
Time
Figure 2.1 the business cycle
Peak- the economy is at full employment and the national output is also at, or very close,
capacity. There is shortage of labor, parts and materials. National income and national
product correspond to a very high degree of utilization of labor, factories and offices.
Inflation is usually present in the peak of economic cycle.
Recession or contraction- is a period of at least six months after the peak and before
the trough during which, the economy declines as measured by GDP. During recession
Output, trade, income and employment both decline. Price also decline as
unemployment starts to increase.
Trough- is where output and employment ‘bottom out’ at their lowest level. During this
time, there is an excess amount of unemployment and idle productive capacity.
Businesses are more likely to fail because if low demand for their product. At the trough,
unemployment is high and output is low.
Expansion (recovery): the economy’s level of output and employment expand towards
full employment.
Section reflection/overview
 What is business cycle?

 What are the major characteristics of business cycle?
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PRE-TEST
 Provide your own Definition of inflation and unemployment
SECTION 7: INFLATION, UNEMPLOYMENT AND THE PHILIPS CURVE
Section Objectives

 Define unemployment and inflation
 Explain the relationship between inflation and unemployment.
Section Overview
SECTION 7: INFLATION, UNEMPLOYMENT AND THE PHILIPS CURVE
7.1 Unemployment
7.2 Inflation
7.3 The Trade offs between Inflation and Unemployment- the Philips
7.1 Unemployment
Unemployment rate is the percentage of total labor force that is currently unemployed
(total unemployment divided by total employment force times 100).
Let L denote the labor force, E the number of employed workers, and U the number of
unemployed workers. Because every worker is either employed or unemployed, the labor
force is the sum of the employed and the unemployed:
L=E+U
In this notation, the rate of unemployment is U/L.
There are different types of unemployment:
Frictional unemployment: At any point of time, some workers will be ‘between jobs’. That
is some workers will be in the process of voluntary switching jobs. Others will have job
connections but will be temporarily laid off because of seasonality or model change
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occurs. Example: college graduates.
Structural unemployment; is unemployment resulting from permanent shifts in the

pattern demand for goods and services or from changes in technology. Structurally
unemployed workers have skills that are not in demand by employers because of
permanent changes in the economy.
Cyclical unemployment: is the amount of unemployment resulting from declines in real

GDP during periods of recession or in any period when the economy fails to operate at
its potential.
7.2 Inflation
Inflation is a rising general level of prices. There are different types of inflation:
Demand-pull inflation: changes in the price level have been attributed to an excess of
total demand. The business sector cannot respond to this excess demand by expanding
real output for the obvious reason that all available resources are already fully employed.
Therefore, this excess demand will bid up the price of the fixed real output, causing
demand pull inflation.
Cost push inflation – inflation may arise on the supply or cost side of the market.
Unions have considerable control over wage rates. They obtain a wage increase. Large
corporate employers faced now with increased costs but also in the possession of
considerable market power, push their increased wage cost on to consumers by raising
the prices of their production.
Structural inflation-is due to the change in the structure of total demand. This is due to
the market power of big business and unions. Prices and wages tend to be flexible
upward but inflexible downward.
7.3 The Trade offs between Inflation and Unemployment- the Philips
Curve
Macroeconomic policies are implemented in order to achieve government’s main

objectives of full employment and stable economy through low inflation. We can use
Philips Curve as a tool to explain the trade-off between these two objectives. Philips
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Curve describes the relationship between inflation and unemployment in an economy.

You already know that the Inflation is defined by increase in the average price level of
goods and services over time. Unemployment exists when someone is actively seeking
for job but unable to find any despite their willingness to accept the going market wage
rate. When there is inflation, value of money falls. A low inflation rate indicates that
average price of goods would not rise as high.
New Zealand-born economist A.W Philips first put this theory forward in 1958 gathered
the data of unemployment and changes in wage levels in the UK from 1861 to 1957. He
observed that one stable curve represents the trade-off between inflation and
unemployment and they are inversely/negatively related. In other words, if
unemployment decreases, inflation will increase, and vice versa.
Inflation
(%) Philips curve
Unemployment (%)
The Phillips Curve shows an inverse relationship between inflation and unemployment. It
suggested that if governments wanted to reduce unemployment it had to accept higher
inflation as a trade-off.
For example, after the economy has just been in recession, the unemployment level will
be fairly high. This will mean that there is a labor surplus. As the economy has just
started growing, the aggregate demand (AD) will increase and therefore leading to an
increase in employment. In the beginning, there will be little pressure for a raise in wages.
However, as the economy grows faster and more people are employed, wages will start
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rising slowly. This will increase the firm’s cost of production and the high costs are
usually passed on to the customers in the form of higher prices. Therefore, a decrease in
unemployment has led to an increase in inflation and vice versa.
Not only that, unemployed might suffer from money illusion as they thought the increase
in wages offered to them represented a real wage. They underestimate inflation by not
realizing that higher wages will be eaten up by higher prices. Thus, they will accept job
more readily and this will reduce the frictional unemployment
The relationship we discussed above is a phenomenon in the short-run. But in the long
run, since unemployment always returns to its natural rate, there is no such trade-off.
Using the data from the 1950s and 1960s where the world economy tend to be stable,
Philips Curve relationship proved to be true for many economies such as United States
and UK . However, during 1967-1970 most countries such as US, Britain and France had
doubled their inflation. This was the first sign that the downward relationship in Philips
Curve was not always true. In 70’s the concept of a stable Philips Curve shows a break
down as the economy suffered from both high inflation and high unemployment
simultaneously. The economists refer this kind of situation as stagflation where
stagnant economies and rising inflation occurs together.
 List the types of unemployment.

 What is cost-push inflation?
 Distinguish between cost-push inflation and demand-pull inflation.
 Explain the relationship between inflation and unemployment both in the short
run and long run.
UNIT SUMMARY
1. Gross domestic product (GDP) measures both the income of everyone in the
economy and the total expenditure on the economy’s output of goods and services.
2. Nominal GDP values goods and services at current prices. Real GDP values goods and
services at constant prices. Real GDP rises only when the amount of goods and services
has increased, whereas nominal GDP can rise either because output has increased or
because prices have increased.
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3. GDP is the sum of four categories of expenditure: consumption, investment,

government purchases, and net exports.
4. The consumer price index (CPI) measures the price of a fixed basket of goods and
services purchased by a typical consumer. Like the GDP deflator, which is the ratio of
nominal GDP to real GDP, the CPI measures the overall level of prices.
5. The unemployment rate shows what fraction of those who would like to work do not
have a job. When the unemployment rate rises, real GDP typically grows slower than its
normal rate and may even fall.
6. Inflation is the rise in the general price level. It is attributed to rise in total demand or
rise in the cost of inputs.
7. Inflation and unemployment are inversely related.
POST-TEST
True/False and Explain
1. The market value of all the goods and services produced within a country in a given
time period are included in GDP.
2. Wages paid to households for their labor is part of aggregate income.
3. Transfer payments are included in the government purchases component of
aggregate expenditure.
4. Aggregate income equals aggregate expenditure.
5. Gross domestic product is larger than net domestic product.
Multiple Choice Questions

Based on the information below answer question 1-2
Year Nominal GDP (billions of Real GDP (billions of 2000 GDP
dollars) dollars) deflator
2003 4500 - 150

2004 3100 156
1. What is real GDP in 2003? a. $675,000 billion b. $4,500 billion c. $3,100 billion
d. $3,000 billion
2. What is nominal GDP in 2004? a. $4,836 billion b. $3,100 billion c. $3,000 billion
d. $1,987 billion
Based on the information below answer question 3-10
Consumption expenditure $200 billion
Government purchases $60 billion
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Net taxes $50 billion

Investment 50 billion $50 billion
Corporate profits $30 billion
imports $20 billion
Exports $10 billion
3 .How much is aggregate expenditure? a. $440 billion b. $330 billion c. $300 billion
d. $270 billion
4. How much is GDP? a. $440 billion b. $330 billion c. $300 billion d. $270 billion
5. How much is aggregate income? a. $440 billion b. $330 billion c. $300 billion
d.$270 billion
6. How much are net exports? a. $20 billion b. $10 billion c. $0 d. -$10 billion
7. How much is household saving? a. $300 billion b. $200 billion c. $100 billion d. $50
billion
8. How much is government saving? a. $60 billion b. $50 billion c. $0 d. -$10 billion
9. How much is national saving? a. $200 billion b. $50 billion c. $40 billion
d. -$10 billion
10. How much is the borrowing from the rest of the world? a. $20 billion b. $10 billion c.
$0 d. -$10 billion
11. Gross private domestic investment is a component of which approach to measuring
GDP? a. Incomes approach b. Expenditure approach c. Linking approach d. Output
approach
12. Which of the following is NOT a component of the incomes approach to GDP?
a. Net exports b. Wages and salaries c. Corporate profits d. Proprietors’ income
13. Which of the following is NOT a reason that real GDP is a poor measure of a nation’s
economic welfare?
a. Real GDP omits measures of political freedom. b. Real GDP does not take into
account the value of people’s leisure time. c. Real GDP does not include the underground
economy. d. Real GDP overvalues household production.
Discussion questions
1. Discuss two imperfections with GDP as a measure of economic well-being?
2. Please, draw a diagram that illustrates the business cycle (time on one axis and
economic activity on the other). Now point out the peaks and troughs of the business
cycle. How these points are typically characterized in terms of unemployment and
inflation
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3. Please, define the natural rate of unemployment. Please list and briefly describe the
three types of unemployment that form the natural rate? What is cyclical unemployment?
REFERENCE
Mankiw, G.(2004) Macroeconomics, 3rd Ed.
Dornbusch R, and Fischer S., (2002) Macroeconomics, 2nd Ed.
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UNIT THREE
MACROECONOMIC FLUCTUATIONS: THE IS-LM APPROACH
UNIT OBJECTIVES
After completing this unit, you are expected to:

 figure out some macroeconomic identities of a closed economy and the concept of
multipliers built on these identities;
 understand how to represent the equilibrium in the real sector of an economy by
the IS curve and what characterizes the slope and position of this curve;
 understand how the money market equilibrium is represented by the LM curve and
what determines the slope and position of this curve; and
 be able to use the IS – LM model to explain short run (macroeconomic)
fluctuations and the impacts of fiscal and monetary policy actions.
UNIT INTRODUCTION
One of the central questions in macroeconomics is why output fluctuates around its
potential level. In business cycle fluctuations, booms and recessions, output fluctuates
relative to the trend of potential output. This unit offers a first theory of these
fluctuations in real output relative to trend. The cornerstone of this model is the
interdependence between output and spending: spending determines output and income,
but output and income determine spending.
The Keynesian model of income determination we develop in this unit is very simple and
will be extended in the fourth unit. The central simplification is that we assume for the
time being that prices do not change at all, and that firms are willing to sell any amount
of output at the given level of prices. Thus the aggregate supply curve is assumed to be
entirely flat. Of course, prices do in fact change. We assume for now that they are
constant in order to develop the notion of aggregate demand. When in unit four the
assumption that prices are fixed and allow them to change, we will find that the
conclusions derived in this unit are qualified, though not reversed. We now study how
the level of output is determined when the aggregate supply curve is flat. The key
concept of equilibrium output is introduced immediately.
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PRE-TEST
 Do you recall, from Unit Two of this course, what business cycle means?
 What determines the trend/potential level of output?
 Why does output deviate from its trend?
SECTION ONE: MACROECONOMIC FLUCTUATIONS
Section Objectives
After completing this section, you should be able to:

 undestand the framework of analysis for studying the interaction of goods and
money markets;
 explain the meaning and determinants of the IS and the LM curves – the two
components of the IS-LM model; and
 use the IS-LM model to discuss how interest rate and income are jointly
determined by equilibrium in the goods and money markets.
Section Overview
SECTION ONE: MACROECONOMIC FLUCTUATIONS
1.1 Quantity-Adjustment versus Price-Adjustment
1.2 The IS-LM Model
1.1 Quantity-Adjustment versus Price-Adjustment Paradigms
The devastating episode of Great Depression caused many economists to question the
validity of classical economic theory. Classical theory seemed incapable of explaining
the Depression. According to the classical economic theory, national income depends
on factor supplies and the available technology, neither of which changed substantially
during the years of Great Depression (1929 to 1933). In 1936 the British economist John
Maynard Keynes revolutionized economics and proposed a new way to analyze the
economy. He proposed that low aggregate demand is responsible for the low income
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and high unemployment that characterize economic downturns. In the long run, prices
are flexible, and aggregate supply determines income. But in the short run, prices are
sticky, so changes in aggregate demand influence income.
Business cycle fluctuations suggest that the economy is often not at its long run or
natural equilibrium. In Unit Two, we defined a business cycle. The conditions that hold in
the long-run equilibrium – like quantity demand equals quantity supplied at full
employment – do not always hold true in the short-run. In this unit we will provide a
theoretical framework to explain and interpret the rather strong and persistent short-run
deviations from long-run equilibrium.
This part of macroeconomic theory is often called the Keynesian model. It is so called
because its origins are found in the work of John Maynard Keynes, a prominent British
economist of the interwar period. In the U.K. from the 1920s on, and in the U.S. and
elsewhere during the Great Depression of the 1930s, it was clear that market
mechanisms were not leading to an equilibrium that utilized all available resources. The
terrible slowness of adjustments in modern macroeconomics needed some explanation.
Dissatisfied with the inability of the classical equilibrium approach to provide an

adequate understanding of the macro phenomena of his time – massive and persistent
unemployment – Keynes developed a theory that provided at least some of the answers.
Keynes’ theory had an overwhelming influence on post-war macroeconomic thinking. In
fact, for sometime, Keynesian modeling became synonymous with macroeconomics.
The Keynesian approach examines the aggregate demand for goods in real terms and
describes the adjustments of the economy towards equilibrium. The simplest Keynesian
model abstracts entirely from price changes. Although this may sound unreasonable, the
model is useful for understanding how short-run output changes occur. The broader
Keynesian model sheds light on the interactions between the demand for goods and
services and the financial sector. It will provide the basis for examining the short-run
effects of monetary and fiscal policy. The Keynesian model is useful for understanding
how the economy adjusts towards its long-run equilibrium.
The principal theme of classical price theory that underlies the study of microeconomics
is: if there is an imbalance between supply and demand in a competitive market, then
prices change to clear the market or establish equilibrium. The emphasis in price theory
is on the balancing role of prices. Real wage flexibility brings about labor sector
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equilibrium and the real interest rate balances the allocation of output between
investment goods and consumption goods. Together, the equilibrium labor supply and
capital stock (in turn determined by the amount of investment) determine the
equilibrium output level.
The Keynesian real sector model takes a different approach. The underlying theme of
this approach is that output or quantity adjustments occur when there is an imbalance
between supply and demand. That is, in the short-run, disequilibrium leads to changes in
the quantity of output. In order to explore this approach we will assume that prices
remain constant and examine the macroeconomic consequences of a model where
quantity adjustments occur.
The simple Keynesian model is an application of the quantity adjustment paradigm. That
is: if there is an imbalance between supply (output or production) and demand
(expenditure), then producers will change the quantity of output produced. The argument
of quantity adjustment can best be made by citing an example of a manufacturing
industry where adjustments in the quantity of output are, at least in the short-run, more
important and more pervasive than adjustments in prices.
Clearly, both price and quantity adjustments take place in actuality; so we will relax the
assumption of fixed prices in Unit Four. There, we will provide a more general discussion
of price changes and the reasons why they do not occur so frequently.
In general, in the short run, a change in price is often a costly and unreliable means of
equilibrating sales and production, particularly when the imbalance may well be a
temporary phenomenon and a rapid response is desired. Thus, quantity adjustments are
the primary adjustment mechanism used to maintain sales-production equilibrium in the
short run. In a modern economy with very rapid information flows and less emphasis on
manufacturing and greater emphasis on services, price changes do occur. Price
changes are often made infrequently and therefore the principal adjustments to supply
and demand imbalances in the short run are quantity changes.
The above conclusion relies upon two characteristics of the product market. First, the
argument presumes that goods can be held in inventory (which is by and large true for
manufactured goods). If output were perishable, price adjustments would dominate. If
we go to the wholesale produce market, we will find that the market for strawberries is
cleared daily by price adjustments. Second, we assume that there is some degree of
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product differentiation. If all output were homogeneous and markets perfectly

competitive then price adjustments would clear the market.
1.2 The IS–LM Model
Over long periods of time, prices are flexible, the aggregate supply curve is vertical, and
changes in aggregate demand affect the price level but not output. Over short periods of
time, prices are sticky, the aggregate supply curve is flat, and changes in aggregate
demand do affect the economy’s output of goods and services.
In the short run when the price level is fixed, shifts in the aggregate demand (AD) curve
lead to changes in national income. The IS – LM model, which is a model of aggregate
demand, aims at showing what determines national income for any given price level or
equivalently at showing what causes the aggregate demand curve to shift.
The two parts of the IS – LM model are the IS curve and the LM curve. IS stands for
“Investment” and “Saving”, and the IS curve represents what’s going on in the market for
goods and services. LM stands for “Liquidity” (which represents the demand for money)
and “Money” (which is the supply/stock of money), and the LM curve represents what’s
happening to the supply and demand for money.
As we will see, the interest rate is the variable that links the two halves of the IS – LM
model since it influences both investment and money demand. The IS – LM model
shows how interactions between these markets determine the position and slope of the
aggregate demand curve and, therefore, the level of national income in the short run.
In the subsections to follow (and before we derive the IS and the LM curves), we will take
sometime to discuss the determination of income, some macroeconomic identities, and
the concept of the multiplier. We will then derive the two curves – the IS curve and the
LM curve – and then bring them together to define a general equilibrium of the economy.
In so doing, we analyze the demand side of the economy only, assuming that the supply
side is alright, i.e., we assume that the fixed price we use is consistent with equilibrium
in factor markets. Extending the IS – LM analysis to the derivation of aggregate demand
and introducing changes in price level (on the supply side) is postponed to the next unit.
1.2.1 The Goods Market and the IS Curve
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The IS curve plots the relationship between the interest rate and the level of income that
arises in the market for goods and services. As to Keynes, an economy’s total income is,
in the short run, determined largely by the desire to spend by households, firms, and the
government. The more people want to spend, the more goods and services firms can
sell. The more firms can sell, the more output they will choose to produce and the more
workers they will choose to hire. Thus, the problem during recessions and depressions,
according to Keynes, was inadequate spending, i.e., shortage of aggregate demand.
1.2.1.1 The Keynesian Cross and Income Determination
To develop the relationship between the interest rate and the level of income that arises
in the market for goods and services – i.e., the IS curve – we start with a basic model
called the Keynesian cross. This model is the simplest interpretation of Keynes’s theory
of national income and is a building block for the more complex and realistic IS – LM
model. The Keynesian cross begins by drawing a distinction between actual expenditure
and planned expenditure.
Actual expenditure is the amount households, firms and the government spend on
goods and services, and it equals the economy’s gross domestic product (income).
Recall that the expenditure approach is one of the approaches of measuring GDP. The
fact that actual expenditure equals real GDP or output is shown in Figure 3.1 below. In
the figure, an actual expenditure of say 10 billion Birr is translated to a 10 billion Birr
value for GDP, giving rise to a 450 line relating AE and GDP.
AE
90
10
450
10 90 Y (= output,
GDP)
Figure 3.1: Actual Expenditure
Now consider planned expenditure and its determinants. Planned Expenditure (PE) is the
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amount households, firms, and the government would like to spend on goods and
services. Assuming that the economy is closed, so that net exports are zero, we can
write planned expenditure (PE) as the sum of consumption C, planned investment I, and
government purchases G:
PE = C + I + G.
To this equation, we add the consumption function C = C(Y − T). This equation states
that consumption depends on disposable income (Y − T), which is total income Y minus
taxes (net of subsidy) T (i.e., T = taxes – subsidies). Assume that fiscal policy – the
levels of government purchases and taxes – is fixed: and . To keep things
simple, also assume that planned investment is exogenously fixed: .
Combining these equations, we obtain:
.
This equation shows that planned expenditure is a function of income Y, the level of
planned investment , and the fiscal policy variables and .
Figure 3.2 graphs planned expenditure (PE) as a function of the level of income. The PE
line slopes upward because higher income leads to higher consumption and thus higher
planned expenditure.
PE
MPC
1
Figure 3.2: Planned Expenditure
The slope of the PE line is the marginal propensity to consume, the MPC: it shows how
much planned expenditure increases when income rises by a unit (say, 1 Birr). This
planned expenditure function is the first piece of the model called the Keynesian cross.
Why would actual expenditure ever differ from planned expenditure? The answer is that
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firms might engage in unplanned inventory investment because their sales do not meet
their expectations. When firms sell less of their product than they 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
investment spending by firms, actual expenditure can be either above or below planned
expenditure. Put differently, while actual expenditure includes unexpected (undesired)
changes in inventories (∆inv), planned expenditure excludes the unexpected (undesired)
changes in inventories. That is, AE = C(Y – T) + I + ∆inv + G while PE = C(Y – T) + I +G.
AE > PE when ∆inv > 0; AE < PE whenever ∆inv < 0; and, AE = PE when ∆inv = 0.
The second piece of the Keynesian cross is the assumption that the economy is in
equilibrium when actual expenditure equals planned expenditure. This assumption is
based on the idea that when people’s plans have been realized, they have no reason to
change what they are doing. Recalling that Y as GDP equals not only total income but
also total actual expenditure on goods and services, we can write this equilibrium
condition as: Actual Expenditure (AE or Y) = Planned Expenditure (PE).
Continuing with our previous assumption of exogenously fixed planned investment (I)
and fiscal policy variables (G and T), the actual expenditure (AE), the planned
expenditure (PE), and the equilibrium of the economy can be shown as follows. Figure
3.3 below shows three pieces which constitute the Keynesian cross – AE, PE and
equilibrium of the economy – together with the role of inventories in the adjustment
towards equilibrium.
AE=PE
PE
AE2
E PE2
Ye
PE1
AE1
450
Y1 Ye Y2 Y, AE
Figure 3.3: The Keynesian Cross and Adjustment to the Equilibrium
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The 450 line serves as a reference line that translates any horizontal distance into an
equal vertical distance. Thus, anywhere on the 450 line, AE = PE, the level of planned
spending (aggregate demand) is equal to the level of actual spending (output). The
equilibrium of this economy is at point E, where the planned expenditure function
crosses the 45-degree line. At this point, the quantity of output produced (output) is
exactly equal to the quantity demanded (planned spending) – both are equal to Ye.
How does the economy get to the equilibrium if it were out of equilibrium? In this model,
inventories play an important role in the adjustment process. Whenever the economy is
not in equilibrium, firms experience unplanned changes in inventories (∆inv ≠ 0), and this
induces them to change production levels. Changes in production in turn influence total
income and expenditure, moving the economy toward equilibrium.
For example, suppose the economy were ever to find itself with GDP at a level greater
than the equilibrium level, such as the level Y2 in Figure 3.3. Then output or actual
expenditure (AE2) would exceed demand or planned expenditure (PE2). Firms would be
unable to sell all they produce and would find their warehouses filling with inventories of
unsold goods. This unplanned rise in inventories induces firms to lay off workers and
reduce production, and these actions in turn reduce GDP. This process of unintended
inventory accumulation and falling income continues until income Y falls to the
equilibrium level (Ye). This is shown by the horizontal arrow pointing left from the output
level of Y2.
Similarly, suppose GDP were at a level lower than the equilibrium level, such as the level
Y1 in Figure 3.3. In this case, planned expenditure PE1 is greater than production AE1.
Firms meet the high level of sales by drawing down their inventories. But when firms see
their stock of inventories dwindle, they hire more workers and increase production. GDP
rises and the economy approaches the equilibrium as shown by the horizontal arrow
pointing to the right from the output level of Y1.
Thus at point E, the equilibrium level of output, firms are selling as much as they produce,
people are buying the amount they want to purchase, and there is no tendency for the
level of output to change. At any other level of output, the pressure from increasing or
declining inventories causes firms to change the level of output.
1.2.1.2 Some National Income Identities of the Closed Economy
1. Consumption and Saving Functions
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We assume that consumption demand increases with the level of disposable or after-tax
income (Yd = Y – T): . The component , the intercept, represents the level
of consumption when income is zero. Regarding the second component, for every Birr
increase in income, consumption increases by c Birr. For example, if c is 0.75, then for
every Birr increase in income, consumption rises by 0.75 cents. The slope of the
consumption function is c.
The coefficient c has a special name, the marginal propensity to consume. The marginal
propensity to consume is the increase in consumption per unit increase in income. The
marginal propensity to consume is less than 1, which implies that out of a Birr increase
in income, only a fraction, c, is spent on consumption. Thus, 0 < c < 1.
What happens to the rest of income, the fraction (1 – c), that is not spent on
consumption? If it is not spent, it must be saved. Income is either spent or saved; there
are no other uses to which it can be put. It follows that any theory that explains
consumption is equivalently explaining the behavior of saving. More formally,
, i.e., income that is not spent on consumption is saved, or by definition
saving is equal to (disposable) income minus consumption . Thus, the
consumption function corresponds to the saving function
which simplifies to . From this equation, we see that
saving is an increasing function of the level of income because the marginal propensity
to save, s = 1 – c, is positive. In other words, saving increases as income rises. For
instance, suppose the marginal propensity to consume, c, is 0.75, meaning that 75 cents
out of each extra Birr of income is consumed. Then the marginal propensity to save, s, is
0.25, meaning that the remaining 25 cents of each extra Birr of income is saved.
Two points need to be made about the consumption function. First, individuals'
consumption demands are related to the amount of income they have available to spend,
i.e., their disposable income (Yd), rather than just to the level of output. Second, how can
individuals consume anything when their income is zero? For some time, they can sell
off their assets such as stocks, bonds, and the house. Eventually, though, it would be
difficult to continue to buy goods when income is zero.
2. Planned versus Actual Investment
There is a useful alternative formulation of the equilibrium condition that aggregate

demand (planned expenditure) is equal to output (actual expenditure). This is to state
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that, in equilibrium, planned investment equals actual investment. This condition follows
from planned expenditure (PE) and actual expenditure (AE) equations we saw under
Keynesian cross and income determination.
There, we said that PE = C(Y – T) + I + G and AE = C(Y – T) + I + ∆inv + G; where I is

planned investment (IPLANNED) and I + ∆inv is actual investment (IACTUAL). Equating PE to
AE is consequently equivalent to equating actual investment to planned investment.
Thus, it always holds that actual investment equals planned investment plus undesired
changes in inventories (IACTUAL = IPLANNED + ∆inv). It follows that at equilibrium (where PE
= AE) planned investment must equal actual investment (IACTUAL = IPLANNED). This requires
that there is no undesired or unplanned change in inventories, i.e., ∆inv = 0. Thus, the
equilibrium condition PE = AE could be stated as IACTUAL = IPLANNED or as ∆inv = 0.
3. The Saving-Investment Identities
There is still another useful alternative formulation of the equilibrium condition that
aggregate demand is equal to output. This condition is the saving-investment identity.
With our assumption of a closed economy (i.e., with zero net export), the equilibrium
condition PE = AE is the same as saying that investment equals saving.
To reiterate, planned expenditure PE is the sum of consumption and investment plans of

households and firms (C + I) and government purchases (G). That is to say, planned
expenditure is given by PE = C + I + G. Similarly, we also saw that actual expenditure (AE)
is the same as output or income (Y), i.e., AE = Y.
Hence, the condition PE = AE = Y is the same as saying that Y = C + I + G and this could
be rewritten in a number of ways. One way is to subtract taxes from both sides of this
equation to find:
Y – T = C + I + G – T.
Now, recall that Y – T is disposable income which is either consumed or saved. So,
Yd = C + I + (G – T).
d
If we take a hypothetical economy with no government (i.e., G = T = 0), it follows that: Y
= C + I.
Subtracting C from both sides yields Yd – C = C + I – C. The left hand side of this identity
(an equation which is always true by definition) is saving and the right hand side is
planned investment. Thus, we have:
S=I
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which is one version of the saving-investment identity.
For the case where there is the government in the economy, subtracting C from both
sides of Yd = C + I + (G – T) gives:
Yd – C = I + (G – T).
Moving (G – T) to the left of the equality sign, we will have:
Yd – C + (T – G) = I
Yd – C on the left is saving by the private sector of the economy, say denoted by SP. The
other term on the left, T – G, is the difference between what government collects as
taxes (net of transfer payments) and government purchases planned. In short, T – G is
saving by government or the public sector, denoted by SG. Now, consequently, the
identity Yd – C + (T – G) = I reduces to SP + SG = I. Replacing the sum of the savings of
the private and public sectors by a single variable S (which is national saving) yields
another version of the saving-investment identity:
S (= SG + SP) = I.
In sum, the condition S = I is merely another way of stating the basic equilibrium
condition.
4. The Injection – Leakage Identity
We will take a very short time to look at this alternative way of stating the equilibrium
condition. The national income identity of a closed economy Y = C + I + G gives the
sources of national income (Y) to be the (planned) spending by households (C), by firms
(I) and by the government (G).
Viewed from the income allocation side, the income earned in such a closed economy is
shared among tax payments, consumption and saving. What is left over after paying
taxes (T) – i.e., the disposable income will either be consumed (C) or saved (S). Hence, Y
= T + C + S.
Bringing the two sides together:
C + I + G = Y = T + C + S.
In relation to the circular flow of economic activities in a simple closed economy, C, I and
G are injections or additions into the flow while C, S and T represent leakages or
withdrawals from the circle. The total of the injections should be equal to the total of the
withdrawals at the equilibrium of the economy. Thus, C + I + G = T + C + S (or after
eliminating C from both sides) I + G = S + T is another way of representing the
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equilibrium condition.
1.2.1.3 The Multiplier
We have seen the Keynesian cross in Subsection 1.2.1.1. The Keynesian cross we have
seen shows how income Y is determined for given levels of planned investment I and
fiscal policy variables G and T. In this subsection, we use this model to show how
income changes when one of these (exogenous) variables changes. More specifically,
we will consider how output (or GDP) responds to changes in government purchases,
autonomous taxes, or autonomous spending (on consumption or investment). We will
also see the balanced budget multiplier, in which case government increases both
purchases and (autonomous) taxes by the same amount.
First let us how changes in government purchases affect the economy. Because
government purchases are one component of expenditure (PE = C + I + G), higher
government purchases result in higher planned expenditure for any given level of income.
This is shown by upward shift in the PE curve from PE1 to PE2 in Figure 3.4.
AE = PE
PE PE2 = C + I + G2
B
PE2 = Y2
G
PE1 = C + I + G1
Y
PE1 = Y1 A
C
450
PE1 = Y1 PE2 = Y2 Y (Income, Output)
Figure 3.4: The Effect of a Change in Government Purchases on Equilibrium Output
Figure 3.4 shows that raising government purchases by G (from G1 to G2), causes the
planned-expenditure schedule to shift upward from PE1 to PE2 (by G). Consequently,
the equilibrium of the economy moves from point A to point B. This graph also shows
that an increase in government purchases leads to an even greater increase in income.
That is, Y is larger than G.
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For the movement fro A to B, caused by the change in government purchases by G, the
change in Y is shown by the arrows from Y1 to Y2 both on the horizontal and the vertical
axes. It should be clear that the vertical distance between Y1 to Y2 (on the vertical axis) is
the same as the distance from Point B to Point C. Y shown by this distance is greater
than the distance between the two planned expenditure curves.
The ratio Y/G is called the government purchases multiplier; it tells us how much
income rises in response to a 1 Birr increase in government purchases. An implication of
the Keynesian cross is that the government-purchases multiplier is larger than 1.
Why does fiscal policy have a multiplied effect on income? The reason is that, according
to the consumption function C = C(Y − T), higher income causes higher consumption.
When an increase in government purchases raises income, it also raises consumption,
which further raises income, which further raises consumption, and so on. Therefore, in
this model, an increase in government purchases causes a greater increase in income.
How big is the multiplier? To answer this question, we trace through each step of the
change in income. The process 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 expenditure and income once again. This second increase in income of MPC × G
again raises consumption, this time by MPC × (MPC × G), which again raises
expenditure and income, and so on. This feedback from consumption to income to
consumption continues indefinitely. The total effect on income is:
Round The Effect of G

on Consumption on Income
1 - G
2 MPC x G MPC x G
3 MPC2 x G MPC2 x G
4 MPC3 x G MPC3 x G
SUM C = (MPC + MPC2 + MPC3 +…) x G Y = (1 + MPC + MPC2 + MPC3 +…) x G
Dividing the two sides of the final equation in the last row of the table above, the
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government purchases multiplier is given by:

Y/G = 1 + MPC + MPC2 + MPC3 +…
This expression for the multiplier is an example of an infinite geometric series. With the
first term of 1 and a common ratio equal to MPC (0 < MPC < 1), the sum of this series
converges to: . Thus, .
Alternatively, the government-purchases multiplier can be derived using calculus as

follows:
Begin with the equation Y = C(Y − T) + I + G. Next, differentiate this equation with respect
to G to obtain:
Holding T and I fixed (assuming that dT/dG = dI/dG = 0) we will have:
Inspection of the multiplier in this formula shows that the larger the marginal propensity
to consume, the larger the multiplier. With a marginal propensity to consume of 0.8, for
instance, the multiplier is 5; for a marginal propensity to consume of 0.9, the multiplier is
10. A higher marginal propensity to consume implies that a larger fraction of an
additional Birr of income will be consumed, thereby causing a larger induced increase in
demand.
Why focus on the multiplier'? The reason is that we are developing an explanation of
fluctuations in output. The multiplier suggests that output changes when government
purchases changes, and that the change in output is larger than the change in
government purchases. The multiplier is the formal way of describing a commonsense
idea: if the economy experiences a shock that reduces income, then people whose
incomes have gone down will spend less, thereby driving equilibrium income down even
further. The multiplier is therefore part of an explanation of why output fluctuates.
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We can derive the multiplier not only for changes in government purchases but also for
changes in any of the components of planned expenditure. Substitute the consumption
function (where Ca is autonomous consumption and c is the MPC)
into the equilibrium condition Y = C + I + G yields:
which, upon rearranging, gives:
Taking the derivative of this equilibrium income, we will have:
From this final expression, it is now easier to derive different multipliers:
That is, the multiplier we saw above, 1/(1-MPC) equally holds for changes occurring to
autonomous consumption spending as well as changes in autonomous investment
spending.
From the same expression we also obtain: . This expression is the tax
multiplier, the amount income changes in response to a 1 Birr change in taxes. For
example, if the marginal propensity to consume is 0.6, then the tax multiplier is
. In this example, a 1 Birr cut in taxes raises equilibrium income by
1.5 Birr.
Finally, let us derive the balanced budget multiplier. What will be the change in income if
government raises both purchases and autonomous taxes by the same amount, i.e., if
G = T? While the increase in government purchases of G pushes up the national
income by , the rise in taxes pulls national income by the amount of
. The net effect on income is therefore given by:
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Using the fact that G = T,
Thus, the balanced budget multiplier is: .
All the multipliers we have seen are based on the assumption of lumpsum taxes. A
similar analysis could be done when taxes are proportional to income (i.e., with variable
taxes). What it requires is a simple calculus.
1.2.1.4 Interest Rate, Investment and the IS Curve
The Keynesian cross is useful because it shows how the spending plans of households,
firms, and the government determine the economy’s income. Yet it makes the
simplifying assumption that the level of planned investment I is fixed. But, an important
macroeconomic relationship is that planned investment depends on the interest rate, r –
i.e., I = I(r). Because the interest rate is the cost of borrowing to finance investment
projects, an increase in the interest rate reduces planned investment. As a result, the
investment function slopes downward.
To determine how income changes when the interest rate changes, we can combine the
investment function with the Keynesian-cross diagram. Figure 3.5 depicts this. Because
investment is inversely related to the interest rate, an increase in the interest rate from r1
to r2 reduces the quantity of investment from I1 to I2. The reduction in planned
investment, in turn, shifts the planned-expenditure function downward, as in panel (b) of
the figure above. The shift in the planned-expenditure function causes the level of
income to fall from Y1 to Y2. Hence, an increase in the interest rate lowers income. The
IS curve, shown in panel (c) of the figure, summarizes this relationship between the
interest rate and the level of income.
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Panel (b): The Keynesian Cross AE = PE

PE1 = C+I1+G
PE
B
PE1
PE2 = C+I2+G
I A
PE2
Y
0
45
Y2 Y1 Y (Income, Output)
Panel (a): The Investment Function

r r
Panel (c): The IS Curve

r2 r1
S
r1 r2 D
I(r) IS
I Y
I2 I1 I Y2 Y1 Y
Figure 3.5: Deriving the IS Curve
In essence, the IS curve combines the interaction between r and I expressed by the
investment function and the interaction between I and Y demonstrated by the Keynesian
cross. Because an increase in the interest rate causes planned investment to fall, which
in turn causes income to fall, the IS curve slopes downward.
The IS curve shows us, for any given interest rate, the level of income that brings the
goods market into equilibrium. As we learned from the Keynesian cross, the level of
income also depends on fiscal policy. The IS curve is drawn for a given fiscal policy; that
is, when we construct the IS curve, we hold G and T fixed. When fiscal policy changes,
say G rises the IS curve shifts (to the right). We can use the Keynesian cross to see how
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changes in fiscal policy shift the IS curve. Because a decrease in taxes also expands
expenditure and income, it too shifts the IS curve outward. A decrease in government
purchases or an increase in taxes reduces income; therefore, such a change in fiscal
policy shifts the IS curve inward.
We have shown that the IS curve is negatively sloped, reflecting the decrease in
aggregate demand associated with a rise in the interest rate. We can also derive the IS
curve by using the goods market equilibrium condition, that income equals planned
spending, or Y = C + I + G.
Let us use our consumption function we described earlier (C = Ca + c(Y – T)) and a linear
investment function (I = Ia – br) where Ia is autonomous investment, r is the interest rate
and b is a positive constant. The goods market equilibrium condition now becomes:
Y = Ca + c(Y – T) + Ia – br + G.
Rearranging and solving for r gives:
From this equation, we see that a higher interest is associated with a lower level of
equilibrium income for given values of the other variables. The equation also gives us
the slope of the IS curve: .
The steepness of the IS curve depends on how sensitive investment spending is to

changes in the interest rate (b) and also on the multiplier. Suppose that investment
spending is very sensitive to the interest rate, so that b is large. Then, in terms of Figure
3.5, a given change in the interest rate produces a large change in planned expenditure
(aggregate demand), and thus shifts the aggregate demand curve up by a large amount.
A large shift in the aggregate demand schedule produces a correspondingly large
change in the equilibrium level of income. If a given change in the interest rate produces
a large change in income, the IS curve is very flat. This is the case if investment is very
sensitive to the interest rate, that is, if b is large. Correspondingly, with b small and
investment spending not very sensitive to the interest rate, the IS curve is relatively steep.
The point of the above paragraph can be inferred from the derivative of the
with respect to b. Since (1 – c) and b2 are both
positive, the relationship between the slope of the IS curve ( ) and the sensitivity
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of investment to interest rate (b) is a positive one. The more sensitive investment
spending is to changes in interest rate, the larger will be the slope of the IS curve. For
instance, if b = 2 and c = 0.6, the slope of the IS curve will be . If we take
b = 4 and c = 0.6 (when investment is more sensitive to interest rate), the IS curve will
have a slope of – 0.1 [= ]. Note that – 0.1 > – 0.2.
Similarly, we can examine how the slope of the IS curve is affected by the value of the
multiplier. Recall that the multiplier in our simple closed economy is . Substituting
into the expression for the slope of the IS curve (slope = ), we will
have . It, then, follows that:
For instance, if b = 4 and c = 0.6, the slope of the IS curve will be . If we
take b = 4 and c = 0.8 (a case where the MPC and thus the multiplier is larger), the IS
curve will have a slope of – 0.05 [= ]. And note, once again, that – 0.05
> – 0.1. The larger the marginal propensity to consume (c) and the larger the multiplier
(m), the larger will be the slope of the IS curve. That is, the larger the multiplier, the
flatter the IS curve. Equivalently, the larger the multiplier, the larger the change in income
produced by a given change in the interest rate; the larger the multiplier, the smaller the
change in the interest rate needed to bring about a given change in income.
Points above and to the right of the IS schedule such as Point S (refer Point S in Panel (c)
of Figure 3.5 above) correspond to an excess supply of goods, and points below and to
the left to an excess demand for goods. At a point such as S, for any level of income (Y),
interest rates are higher than at a point on the IS curve. At the higher interest rates,
planned investment spending is too low, and thus output exceeds planned spending and
there is an excess supply of goods. Points below and to the left of the IS curve are
points of excess demand for goods. At a point like D, the interest rate is too low and
aggregate demand is therefore too high relative to output.
In summary,
1. The IS curve shows the combinations of the interest rate and the level of income
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that are consistent with equilibrium in the market for goods and services. It does
not determine either income Y or the interest rate r. Instead, the IS curve is just a
relationship between Y and r arising in the market for goods and services.
2. The IS curve is negatively sloped because an increase in the interest rate reduces
planned investment spending and therefore reduces aggregate demand, thus
reducing the equilibrium level of income.
3. At points to the right of the curve, there is excess supply in the goods market; at
points to the left of the curve, there is excess demand for goods.
4. The smaller the multiplier and the less sensitive investment spending is to
changes in the interest rate, the steeper the IS curve.
5. 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 shift the IS curve to
the left. The IS curve is also shifted by changes in autonomous (consumption and
investment) spending of the private economic agents.
1.2.2 The Money Market and the LM Curve
The money market is just one component of the broader concept of assets markets. The
assets markets are the markets in which money, bonds, stocks, houses, and other forms
of wealth are traded. So far we have ignored the role of these markets in affecting the
level of income, and now will take it up.
We shall simplify matters by grouping all available assets into two groups, money and
interest-bearing asset. Thus we proceed as if there are only two assets, money and all
others. It will be useful to think of the other assets as marketable claims to future
income, such as bonds, just as Keynes did in his Theory of Liquidity Preferences.
At any given time, an individual has to decide how to allocate his or her financial wealth
between alternative types of assets – say, money and bond. The more bonds held, the
more interest received on total financial wealth. The more money held, the more likely
the individual is to have money available when he or she wants to make a purchase. The
person who has 10,000 Birr in financial wealth has to decide whether to hold, say, 9,000
Birr in bonds and 1,000 in money, or rather, 5,000 Birr in each type of asset, or even
10,000 Birr in money and none in bonds. Such decisions on the form in which to hold
assets are portfolio decisions. This example makes it clear that the portfolio decisions
on how much money to hold and on how many bonds to hold are really the same
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decision.
Given the level of financial wealth, the individual who has decided how many bonds to
hold has implicitly also decided how much money to hold. There is a wealth budget
constraint which states that the sum of the individual's demand for money and demand
for bonds has to add up to that person's total financial wealth. This implies that we can
discuss assets markets entirely in terms of the money market. Why? Because, given real
wealth, when the money market is in equilibrium, the bond market will turn out also to be
in equilibrium.
The LM curve plots the relationship between the interest rate and the level of income
that arises in the market for money balances. The building block for this relationship is
called the theory of liquidity preference, a theory of the interest rate. The explanation of
how the interest rate is determined in the short run is called the theory of liquidity
preference, because it posits that the interest rate adjusts to balance the supply and
demand for the economy’s most liquid asset – money.
1.2.2.1 The Theory of Liquidity Preference
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 that there is a
fixed supply of real money balances. That is, = .
The money supply M is an exogenous policy variable chosen by a central bank (National
Bank of Ethiopia in our case). The price level P is also an exogenous variable in this
model. We take the price level as given because the IS – LM model – our ultimate goal in
this unit – explains the short run when the price level is assumed fixed. These
assumptions imply that the supply of real money balances is fixed and, in particular,
does not depend on the interest rate.
The demand for real money balances

The demand for money is a demand for real balances because people hold money for
what it will buy. The higher the price level, the more nominal balances a person has to
hold to be able to purchase a given quantity of goods. If the price level doubles, then an
individual has to hold twice as many nominal balances in order to be able to buy the
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same amount of goods.
The demand for real balances depends on the level of real income and the interest rate.
It depends on the level of real income because individuals hold money to pay for their
purchases, which, in turn, depend on income. The theory of liquidity preference posits
that the interest rate is one determinant of how much money people choose to hold. The
reason is that the interest rate is the opportunity cost of holding money: it is what you
forgo by holding some of your assets as money, which does not bear interest, instead of
interest-bearing assets like bonds. When the interest rate rises, people want to hold less
of their wealth in the form of money. If the interest rate is 1 percent, then there is very
little benefit from holding bonds rather than money. However, when the interest rate is
10 percent, then it is worth some effort not to hold more money than is needed to
finance day-to-day transactions.
On these simple grounds, then, the demand for real balances increases with the level of
real income and decreases with the interest rate. The demand for real balances is
accordingly written as:
; where k, h > 0.
The parameters k and h reflect the sensitivity of the demand for real balances to the
level of income and the interest rate, respectively. A 1 Birr increase in real income raises
money demand by k real Birr. An increase in the interest rate by one percentage point
(say, from 4% to 5%) reduces real money demand by h real Birr.
The demand function for real balances shown above implies that for a given level of
income, the quantity demanded is a decreasing function of the rate of interest. Such a
demand curve is shown in Figure 3.6 for a level of income, Y. The higher the level of
income, the larger is the demand for real balances, and therefore the demand for real
money balances curve shifts to the right.
According to the theory of liquidity preference, the supply of and demand for real money
balances determine what interest rate prevails in the economy. That is, the interest rate
adjusts to equilibrate the money market. As the figure shows, at the equilibrium interest
rate, the quantity of real money balances demanded equals the quantity supplied.
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(M/P)S
r
re
M/P
Figure 3.6: Supply of and Demand for Real Money Balances and Equilibrium in the
Money Market
How does the interest rate get to this equilibrium of money supply and money demand?
The adjustment occurs because whenever the money market is not in equilibrium,
people try to adjust their portfolios of assets and, in the process, alter the interest rate.
For instance, if the interest rate is above the equilibrium level, the quantity of real money
balances supplied exceeds the quantity demanded. Individuals holding the excess
supply of money try to convert some of their non-interest-bearing money into interest-
bearing bonds. Banks and bond issuers, who prefer to pay lower interest rates, respond
to this excess supply of money by lowering the interest rates they offer. Conversely, if
the interest rate is below the equilibrium level, so that the quantity of money demanded
exceeds the quantity supplied, individuals try to obtain money by selling bonds or
making bank withdrawals. To attract now-scarcer funds, banks and bond issuers
respond by increasing the interest rates they offer. Eventually, the interest rate reaches
the equilibrium level, at which people are content with their portfolios of monetary and
non-monetary assets.
A fall in M reduces M/P, because P is fixed in the model. The supply of real money
balances shifts to the left, as in the figure below. The equilibrium interest rate rises from
r1 to r2, and the higher interest rate makes people satisfied to hold the smaller quantity
of real money balances. The opposite would occur if the money supply is increased.
Thus, according to the theory of liquidity preference, a decrease in the money supply
raises the interest rate, and an increase in the money supply lowers the interest rate.
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1.2.2.2 Income, Money Demand, and the LM Curve
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. Earlier
in this subsection, we have said that the quantity of real money balances demanded is
negatively related to the interest rate and positively related to income.
Therefore, according to the theory of liquidity preference, 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 will be, and the higher the equilibrium interest rate. For this reason, the
LM curve slopes upward, as shown in panel (b) of Figure 3.7.
An increase in income (from Y1 to Y2 in Figure 3.7) shifts the money demand curve to the
right. With the supply of real money balances unchanged, the interest rate must rise
from r1 to r2 to equilibrate the money market. The figure shows combinations of interest
rates and income levels such that the demand for real balances exactly matches the
available supply. Starting with the level of income, Y1, the corresponding demand curve
for real balances, (M/P)d1, is shown in Panel (a). The existing supply of real balances,
(M/P)1, is shown by the vertical line, since it is given and therefore is independent of the
interest rate.
At interest rate rl the demand for real balances equals the supply. Therefore, the money
market is in equilibrium. That point is recorded in Panel (b) of the same figure as a point
on the money market equilibrium schedule, or the LM curve. Consider next the effect of
an increase in income to Y2. The higher level of income causes the demand for real
balances to be higher at each level of the interest rate, and so the demand curve for real
balances shifts up and to the right, to(M/P)d2. The interest rate increases to r2 to
maintain equilibrium in the money market at that higher level of income. Accordingly, the
new equilibrium point is associated with a higher interest rate than the old one.
Performing the same exercise for all income levels, we generate a series of points that
can be linked to give us the LM schedule (in Panel (b)).
The LM schedule or money market equilibrium schedule shows all combinations of

interest rates and levels of income such that the demand for real balances is equal to
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the supply. Along the LM schedule, the money market is in equilibrium. The LM curve is
positively sloped. An increase in the interest rate reduces the demand for real balances.
To maintain the demand for real balances equal to the fixed supply, the level of income
has to rise. Accordingly, money market equilibrium implies that an increase in the
interest rate is accompanied by an increase in the level of income.
r (M/P)S r LM
r2 r2
r1 r1
M/P Y1 Y2 Y
Panel (a) Panel (b)
Figure 3.7: Change in Income Affecting the Equilibrium in the Money Market and the LM
Curve
The LM curve can be obtained directly by combining the demand curve for real balances,
and the fixed supply of real balances. For the money market to be in equilibrium,
demand has to equal supply, or
Solving for the interest rate:
This relationship between r and Y is the LM curve.
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The slope of the LM curve is given by . The greater the responsiveness of the
demand for money to income (larger k), and the lower the responsiveness of the
demand for money to the interest rate (lower h), the steeper the LM curve will be.
Points off the LM schedule are characterized as situations of excess demand or excess
supply of money. Any point to the right and below the LM schedule is a point of excess
demand for money since the interest rate is too low and/or the level of income too high
for the money market to clear. Similarly, any point to the left and above the LM curve is a
point of excess supply as the interest rate is too high and/or the level of income too low
for the money market to clear.
The LM curve is drawn for a given supply of real money balances. If real money balances
change – for example, if National Bank of Ethiopia (NBE) alters the money supply – the
LM curve shifts. Suppose that NBE decreases the money supply from M1 to M2, which
causes the supply of real money balances to fall from M1/P to M2/P. The figure that
follows shows what happens.
LM2
r r LM1
r2 r2
r1 r1
M/P Y1 Y
Panel (a) Panel (b)
Figure 3.8: A Policy Change in Money Supply and the Resulting Shift in the LM Curve
Holding constant the amount of income and thus the demand curve for real money
balances, we see that a reduction in the supply of real money balances raises the
interest rate that equilibrates the money market. Hence, a decrease in the money supply
shifts the LM curve upward from LM1 to LM2 .
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In summary,
1. The LM curve shows the combinations of the interest rate and the level of
income which are consistent with equilibrium in the market for real balances.
2. The LM curve is positively sloped. Given the fixed money supply, an increase in
the level of income, which increases the quantity of money demanded, has to be
accompanied by an increase in the interest rate. This reduces the quantity of
money demanded and thereby maintains money market equilibrium.
3. The greater the responsiveness of the demand for money to income (larger k),
and the lower the responsiveness of the demand for money to the interest rate
(lower h), the steeper the LM curve will be.
4. At points to the right of the LM curve, there is an excess demand for money, and
at points to its left, there is an excess supply of money.
5. The LM curve is drawn for a given supply of real money balances. Decreases in
the supply of real money balances shift the LM curve upward. Increases in the
supply of real money balances shift the LM curve downward.
6. The LM curve by itself does not determine either income Y or the interest rate r
that will prevail in the economy. Like the IS curve, the LM curve is only a
relationship between these two endogenous variables.
We are now ready to discuss the joint equilibrium of the goods and assets markets. That
is to say, we can now discuss how output and interest rates are determined. Before we
do that, make sure that you have understood the theme of this subsection.
1.2.3 Simultaneous Equilibrium in the Goods and Money Markets
The IS and LM curves together determine the economy’s equilibrium. Our 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 combinations of r and Y that satisfy
the equation representing the goods market [Y = C(Y–T) + I(r) + G], and the LM curve
provides the combinations of r and Y that satisfy the equation representing the money
market [M/P = L(r, Y)].
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r LM
r*
IS
Y* Y
Figure 3.9: Equilibrium in the IS – LM Model
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 conditions for
equilibrium in both the goods market and the money market. In other words, at this
intersection, actual expenditure equals planned expenditure, and the demand for real
money balances equals the supply.
Section Reflection
 In the Keynesian cross, assume that the consumption function is given by: C =
200 + 0.75(Y – T). Planned investment is 100; government purchases and taxes
are both 100.
a. Graph planned expenditure as a function of income.
b. What is the equilibrium level of income?
c. If government purchases increase to 125, what is the new equilibrium income?
d. What level of government purchases is needed to achieve an income of 1,600?
 If planned investment = 1300 Birr, government purchases = 1050 Birr and taxes =
2000 Birr, find the value of savings by the private agents of this closed economy?
 Why does the IS curve slope downward?
 Use the theory of liquidity preferences to explain why a rise in the money supply
lowers the interest rate. What does this explanation assume about the price level?
 Why does the LM curve slope upward?
 Suppose that the money demand function is (M/P)d = 1,000 − 100r, where r is the
interest rate in percent. The money supply is 1,000 Birr and price level is 2.
e. Graph the supply of and the demand for real money balances.
f. What is the equilibrium interest rate?
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g. What happens to equilibrium r if money supply is raised from 1,000 to 1,200?

h. If the central bank wishes to raise the interest rate to 7 percent, what money
supply should it set?
 Consider a hypothetical closed economy with the following functions: C = 50 +
0.75 Yd; I = 100 – 2r; G = 120; T = 140; Ms = 440; P = 2; (M/P)d = 0.5Y – 1.5r.
i. Write down the IS function.
j. Write down the LM function.
k. Determine the equilibrium levels of income and interest rate.
SECTION TWO: EXPLAINING FLUCTUATIONS WITH THE IS–LM MODEL
Section Objectives
Upon completing this section, you should be expected to:

 use the IS-LM model to discuss the effects of fiscal policy and monetary policy;
 understand the role of interest rate in transmitting the change in one market to the
other market; and
 discuss the impact of coordination (or lack of coordination) the success of a given
policy action.
Section Overview
SECTION TWO: EXPLAINING FLUCTUATIONS WITH THE IS – LM MODEL
2.1 Changes in Fiscal Policy
2.2 Changes in Monetary Policy
2.3 The Interaction between Monetary and Fiscal Policies
2.1 Changes in Fiscal Policy
The intersection of the IS curve and the LM curve determines the level of national
income. When one of these curves shifts, the short-run equilibrium of the economy
changes and national income fluctuates.
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Let us begin this discssion with the effects of fiscal policy actions. Changes in the level
of government purchases or taxes influence planned expenditure and thereby shift the IS
curve. The following figure illustrates this using the case of an increase in G by ∆G.
r LM
B
r2
A C
r1
IS2
IS1
Y1 Y2 Y
Figure 3.10: The Effect of a Change in Government Purchases in the IS – LM Model
The government-purchases multiplier in the Keynesian cross tells us that, at any given
interest rate, this change in fiscal policy raises the level of income by ∆G/(1−MPC).
Therefore, the IS curve shifts to the right by this amount (the distance from A to C). The
equilibrium of the economy moves from point A to point B. The increase in government
purchases raises both income and the interest rate.
When the government increases its purchases of goods and services, the economy’s
planned expenditure rises. The increase in planned expenditure stimulates the
production of goods and services, which causes total income Y to rise. These effects
should be familiar from the Keynesian cross.
Now consider the money market, as described by the theory of liquidity preference.
Because the economy’s demand for money depends on income, the rise in total income
increases the quantity of money demanded at every interest rate. The supply of money,
however, has not changed so higher money demand causes the equilibrium interest rate
r to rise.
The higher interest rate arising in the money market, in turn, has ramifications back in
the goods market. When the interest rate rises, firms cut back on their investment plans.
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This fall in investment partially offsets the expansionary effect of the increase in
government purchases. Thus, the increase in income in response to a fiscal expansion is
smaller in the IS – LM model than it is in the Keynesian cross (where investment is
assumed to be fixed).
In the IS – LM model, changes in taxes affect the economy much the same as changes
in government purchases do, except that taxes affect expenditure through consumption.
Consider, for instance, a decrease in taxes of ∆T. The tax cut encourages consumers to
spend more and, therefore, increases planned expenditure. The tax multiplier in the
Keynesian cross tells us that, at any given interest rate, this change in policy raises the
level of income by ∆T ×MPC/(1 - MPC). The tax cut raises both income and the interest
rate. Once again, because the higher interest rate depresses investment, the increase in
income is smaller in the IS – LM model than it is in the Keynesian cross.
In general, fiscal policy is more effective at influencing national income if:

1. the LM curve is flatter – when demand for real money balances is less sensitive to
changes in income and/or more sensitive to changes in interest rate, and
2. the MPC and the shift in the IS curve are larger, and investment demand is less
sensitive to changes in interest rate – steeper IS curve.
2.2 Changes in Monetary Policy
A change in the money supply alters the interest rate that equilibrates the money market
for any given level of income and, thereby, shifts the LM curve.
Let’s consider an increase in M. An increase in M leads to an increase in real money

balances M/P, because the price level P is fixed in the short run. The theory of liquidity
preference shows that for any given level of income, an increase in the supply of real
money balances leads to a lower interest rate. Therefore, the LM curve shifts downward
as depicted below. The equilibrium moves from point A to point B. The increase in the
money supply lowers the interest rate and raises the level of income.
When the central bank increases the supply of money, people have more money than
they want to hold at the prevailing interest rate. As a result, they start depositing this
extra money in banks or use it to buy bonds. The interest rate r then falls until people are
willing to hold all the extra money that the central bank has created; this brings the
money market to a new equilibrium. The lower interest rate, in turn, has ramifications for
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the goods market. A lower interest rate stimulates planned investment, which increases
planned expenditure, production, and income Y.
r LM1
LM2
A
r1
r2 B
IS
Y1 Y2 Y
Figure 3.11: The Effect of a Change in Money Supply in the IS – LM Model
The IS – LM model shows that an increase in the money supply lowers the interest rate,
which stimulates investment and thereby expands the demand for goods and services a
process called the monetary transmission mechanism.
Monetary policy is more effective at influencing national income if:

1. the IS curve is flatter –lower MPC and sensitive investment to changes in interest
rate is, and
2. the LM curve is steeper – if the demand for real money balances is more sensitive to
changes in income and less sensitive to changes in interest rate.
2.3 The Interaction between Monetary and Fiscal Policies
When analyzing any change in monetary or fiscal policy, it is important to keep in mind
that the policymakers who control these policy tools are aware of what the other
policymakers are doing. A change in one policy, therefore, may influence the other, and
this interdependence may alter the impact of a policy change. For example, suppose
government were to raise taxes. What effect should this policy have on the economy?
According to the IS – LM model, the answer depends on how the central bank responds
to the tax increase. The figure below shows three of the many possible outcomes.
In panel (a), the central bank holds the money supply constant. The tax increase shifts
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the IS curve to the left. Income falls (because higher taxes reduce consumer spending),
and the interest rate falls (because lower income reduces the demand for money). The
fall in income indicates that the tax hike causes a recession.
Figure 3.12: The Interaction between Monetary and Fiscal Policy

In panel (b), the central bank wants to hold the interest rate constant. In this case, when
the tax increase shifts the IS curve to the left, the central bank must decrease the money
supply to keep the interest rate at its original level. This fall in the money supply shifts
the LM curve upward (to the left). The interest rate does not fall, but income falls by a
larger amount than if the central bank had held the money supply constant. Whereas in
panel (a) the lower interest rate stimulated investment and partially offset the
contractionary effect of the tax hike, in panel (b) the central bank deepens the recession
by keeping the interest rate high.
In panel (c), the central bank wants to prevent the tax increase from lowering income. It
must, therefore, raise the money supply and shift the LM curve downward enough to
offset the shift in the IS curve. In this case, the tax increase does not cause a recession,
but it does cause a large fall in the interest rate. Although the level of income is not
changed, the combination of a tax increase and a monetary expansion does change the
allocation of the economy’s resources. The higher taxes depress consumption, while the
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lower interest rate stimulates investment. Income is not affected because these two
effects exactly balance.
From this example we can see that the impact of a change in fiscal policy depends on
the policy the central bank pursues – that is, on whether it holds the money supply, the
interest rate, or the level of income constant. More generally, whenever analyzing a
change in one policy, we must make an assumption about its effect on the other policy.
The most appropriate assumption depends on the case at hand and the many political
considerations that lie behind economic policymaking.
Section Reflection
 Consider a hypothetical closed economy with: C = 50 + 0.75Yd; I = 100 – 2r; G=

s d
120; T = 140; M = 440; P = 2; (M/P) = 0.5Y – 1.5r. If government purchases
increases by 220,
a. What is the impact of this change on the IS curve?
b. What is the impact of the change on the equilibrium level of income?
c. What should the central bank do in order to neutralize the impact of the change in
government purchases on output given under (b)? Should it increase or decrease
the money supply? By what amount?
UNIT SUMMARY
Business cycle fluctuations suggest that the economy is often not at its long run or
natural equilibrium. In the short run, a change in price is often a costly and unreliable
means of equilibrating sales and production, particularly when the imbalance may well
be a temporary phenomenon and a rapid response is desired. Thus, quantity
adjustments are the primary adjustment mechanism used to maintain sales-production
equilibrium in the short run. The Keynesian approach examines the aggregate demand
for goods in real terms and describes the adjustments of the economy towards
equilibrium. The simplest Keynesian model abstracts entirely from price changes.
In a closed economy, planned expenditure (or aggregate demand) consists of planned

spending by households on consumption, by firms on investment goods, and by
government on its purchases of goods and services. Actual expenditure (or GDP) adds
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undesired changes in inventories to these components of planned expenditure.
Output is at its equilibrium level when the planned expenditure is equal to the level of
actual expenditure or output. When output is at its equilibrium level, there are no
unintended changes in inventories and all economic units are making precisely the
purchases they had planned to. An adjustment process for the level of output based on
the accumulation or rundown of inventories leads the economy to the equilibrium output
level. The equilibrium condition that planned expenditure equals actual expenditure can
be stated in different ways: planned investment equals actual investment, undesired
change in inventories is zero, savings equal investment, or leakages equal injection.
The consumption function relates consumption spending to income. Consumption rises

with income. Income that is not consumed is saved, so that the saving function can be
derived from the consumption function. The multiplier is the amount by which a 1 Birr
change in autonomous spending changes the equilibrium level of output. We have
different multipliers. The greater the marginal propensity to consume is, the higher will
be the government purchases multiplier.
The Keynesian cross is a basic model of income determination. It takes fiscal policy and
planned investment as exogenous and then shows that there is one level of national
income at which actual expenditure equals planned expenditure. It shows that changes
in fiscal policy have a multiplied impact on income. Once we allow planned investment
to depend on the interest rate, the Keynesian cross yields a relationship between the
interest rate and national income. A higher interest rate lowers planned investment, and
this in turn lowers national income. The downward-sloping IS curve summarizes this
negative relationship between the interest rate and income.
The theory of liquidity preference is a basic model of the determination of the interest
rate. It takes the money supply and the price level as exogenous and assumes that the
interest rate adjusts to equilibrate the supply and demand for real money balances. The
theory implies that increases in the money supply lower the interest rate. Once we allow
the demand for real money balances to depend on national income, the theory of
liquidity preference yields a relationship between income and the interest rate. A higher
level of income raises the demand for real money balances, and this in turn raises the
interest rate. The upward-sloping LM curve summarizes this positive relationship
between income and the interest rate.
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The IS-LM model is the basic model of aggregate demand that incorporates the assets
markets as well as the goods market. It is a general theory of the aggregate demand for
goods and services. The exogenous variables in the model are fiscal policy, monetary
policy, and the price level. The model explains two endogenous variables: the interest
rate and the level of national income. The interest rate and level of output are jointly
determined by the simultaneous equilibrium of the goods and money markets. This
occurs at the point of intersection of the IS and LM curves.
Assuming that output is increased when there is an excess demand for goods and that
the interest rate rises when there is an excess demand for money, the economy does
move toward the new equilibrium when one of the curves shifts. Typically we think of the
assets markets as clearing rapidly so that, in response to a disturbance, the economy
tends to move along the LM curve to the new equilibrium. Whenever analyzing a change
in one policy, we must make an assumption about its effect on the other policy and how
the other policy authority would respond.
POST-TEST
I. Write True If the Statement Is Correct and False If Not.
1. Unforeseen accumulation of inventories induces firms to produce more and hence it

raises total spending.
2. The demand for real money balances varies inversely with the level of income and
the rate of interest.
3. Increasing government purchases of goods and services has a greater impact on the
IS curve than on the equilibrium income of the economy.
4. The flatter the LM curve and the steeper the IS curve, the more effective will be fiscal
policy at influencing the level of national income.
5. The LM curve is vertical if real money demand is completely irresponsive to changes
in income level.
II. Answer Each of the Following Questions.
6. Assuming fixed investment, fixed lumpsum taxes and an MPC of 0.7 for a
hypothetical closed economy, what is the impact of simultaneously increasing both
taxes and government purchases by Birr 60 billion?
7. Although the Keynesian cross in this unit assumes that taxes are a fixed amount, in
many countries taxes depend on income. Let’s represent the tax system by writing
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tax revenue as , where and t are parameters of the tax code. t is the
marginal tax rate: if income rises by 1 Birr, taxes rise by t Birr.
a. How does this tax system change the way consumption responds to changes in
GDP?
b. In the Keynesian cross, how does this tax system alter government-purchases
multiplier?
c. How does this tax system alter the slope of the IS curve?
8. Given G – T = 225, S = 275 +1000r, I = 100 – 250r, where G – T denotes the budget
deficit, S denotes household savings, I denotes planned investment, and r denotes
the real interest rate (written as a decimal: e.g. if the real interes rate is 10%, it is
weitten as r = 0.10),
a. What is the equilibrium interest rate in this economy?
b. What is the quantity of national savings in this economy?
9. Consider an economy with the consumption function C = 200 + 0.75(Y − T), the
investment function I = 200 − 25r, government purchases G = 100, taxes T = 100, the
money demand function (M/P)d = Y − 100r, the money supply M = 1,000 and the price
level P = 2.
a. Graph the IS curve for this economy.
b. Graph the LM for this economy.
c. Find the equilibrium interest rate r and the equilibrium level of income Y.
d. Suppose that government purchases are raised from 100 to 150.
i. How much does the IS curve shift?
ii. What are the new equilibrium interest rate and level of income?
e. Suppose instead that the money supply is raised from 1,000 to 1,200.
i. How much does the LM curve shift?
ii. What are the new equilibrium interest rate and level of income?
REFERENCES
Blanchard, O. (2000). Macroeconomics, 2nd ed. Prentice Hall, Inc.

Branson, W. (1998). Macroeconomic Theory and Practice, 3rd ed.
Dornbush, R. and S. Fischer (2002). Macroeconomics, 6th ed. McGraw-Hill.
Mankiw, G. (2004). Macroeconomics, 5th ed. Worth publishers.
Wachtel, P. (1997). Macroeconomics, 4th Printing. The Society of Actuaries.
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UNIT FOUR
AGGREGATE DEMAND AND AGGREGATE SUPPLY
UNIT OBJECTIVES
On completing this unit and the relevant reading, you should be able to:
 derive the aggregate demand (AD) curve from the IS – LM model, and illustrate the
determinants of the position and the slope of the AD curve;
 describe alternative explanations for the positive slope of the aggregate supply (AS)
curve in the short run;
 explain the determinants of the position and the slope of the aggregate supply
curve in the short run and in the long run;
 discuss the role of shocks and fiscal and monetary policy in the determination of
economic activity in the AD – AS model; and
 explain the meaning of the Phillips curve and how its features can be affected by
the time horizon and the assumptions about expectations.
UNIT INTRODUCTION
Why does a government permit recessions to continue, when they can be cured simply
by expansionary monetary or fiscal policy? A large part of the answer is that
expansionary aggregate demand policies increase inflation so that a government
considering whether to increase demand has to weigh the costs of higher inflation
against the benefits of higher output and lower unemployment.
Thus far, we have not looked at inflation; our analysis has assumed that the price level is
fixed. We studied the impacts of changes in the money supply, or of taxes, or of
government spending, assuming that whatever amount of goods was demanded would
be supplied, at the existing price level. But, of course, inflation is one of the major
concerns of citizens, policy makers, and macroeconomists.
The time has therefore come to bring the price level and the inflation ratethe rate of
change of the price level-into the center of our analysis. We use the model of aggregate
demand and supply to study the joint determination of the price level and the level of
output. The aggregate demand curve, AD, which is downward-sloping, is derived from
the IS-LM model. We show why it slopes downward and what causes it to shift. The
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aggregate supply curve, AS, will also be introduced in this chapter. The intersection of
the AD and AS schedules determines the equilibrium level of output and the equilibrium
price level. A shift in either schedule causes the price level and the level of output to
change.
The aggregate demand-supply model is the basic macroeconomic model for studying
output and price level determination. In both macroeconomics and microeconomics,
demand and suply curves are the essential tools for studying output and price
determination. But the aggregate demand and supply curves are not as simple as the
microeconomic demand and supply curves – there is more going on in the background
of the aggregate curves.
PRE-TEST
 How do you think does the aggregate demand (AD) curve differ from the demand
curve for a commodity (from microeconomics)?
 How do think the aggregate supply (AS) curve differ from supply of a single good?
 What factors do you think affect the positions of AD and AS curves?
SECTION ONE: AGGREGATE DEMAND
Section Objectives

 undestand how the aggregate demand curve is derived from the IS-LM model;
 tell why the aggregate demand curve is downward sloping; and
 discuss what factors cause shifts in the aggregate demand curve.
Section Overview
SECTION ONE: AGGREGATE DEMAND
1.1 From the IS-LM Model to the Aggregate Demand Curve
1.2 Charachterizing the Aggregate Demand Curve
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1.1 From the IS–LM Model to the AD Curve
The last unit presented the Keynesian model of the real and monetary sectors of the
economy. It showed how real sector quantity adjustments interact with the demand for
money via the role of interest rates. The model determines the equilibrium values of real
output and interest rates. The Keynesian approach is useful because it shows how the
real and monetary sectors are affected by policy or any other shock to equilibrium.
However, the main drawback of the model is that it retains the assumption that the only
relevant real sector adjustments are quantities produced; prices were assumed
unchanged for the entire discussion. The assumption of fixed or sticky prices is in fact
defensible when we restrict ourselves to very short periods of time. However, any shock
to the economy that is likely to have effects that extend beyond six months or a year is
also going to have implications for price behavior. We will now extend the model so that
we can discuss price behavior and inflation.
We begin this unit with an extension of the Keynesian model that allows us to discuss
price flexibility and relate the Keynesian demand to the long-run neoclassical equilibrium.
This analysis is called aggregate demand and aggregate supply analysis and it relates
the level of output to the price level.
The aggregate demand curve shows how the Keynesian equilibrium changes for
different values of the price level. The aggregate demand curve shows how changes in
the price level affect the IS-LM or demand side equilibrium. We begin by deriving a total
demand curve from the IS-LM analysis.
The Keynesian IS-LM model developed in Unit Three is a model of only demand behavior.
It tells us how the equilibrium between planned aggregate demand and output is
achieved. It describes demand behavior but says absolutely nothing about supply
behavior. The price level is an exogenous variable in the Keynesian aggregate demand
model. That is, it is not determined by the system, although it does appear in the model
structure. The price level determines the real value, or purchasing power, of the nominal
money supply, thus positioning the LM curve and determining the aggregate demand
equilibrium.
The position of the LM curve will change if prices change, and as it does, the output
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equilibrium changes as well. That is, in the IS-LM model there will be a different
equilibrium output for each level of prices. The aggregate demand curve summarizes
this relationship between the price level and the output level determined by the
intersection of the IS and LM curves. The aggregate demand curve is a locus of
Keynesian aggregate demand equilibrium for different price levels.
We have been using the IS – LM model to explain national income in the short run when
the price level is fixed. To see how the IS – LM model fits into the model of aggregate
supply and aggregate demand, we now examine what happens in the IS – LM model if
the price level is allowed to change.
The aggregate demand curve describes a relationship between the price level and the
level of national income. We use the IS – LM model to show why national income falls
as the price level rises – that is, why the aggregate demand curve is downward sloping.
We also examine what causes the aggregate demand curve to shift.
To explain why the aggregate demand curve slopes downward, we examine what
happens in the IS – LM model when the price level changes. If the price level changes
while everything else (including the nominal money supply, M) remains the same, then
the resulting change in the real money supply (M/P) causes the IS-LM equilibrium to
change. To be more precise, consider the situation shown in the Panel (a) of Figure 4.1
below. For the price level P1, the LM curve is given by LM1 and output is Y1.
For any given money supply M, a higher price level P reduces the supply of real money
balances M/P. A lower supply of real money balances shifts the LM curve upward, which
raises the equilibrium interest rate and lowers the equilibrium level of income, as shown
in panel (a). An increase in the price level with a given nominal money supply is
equivalent to a contractionary monetary policy; it reduces the real money supply. The
new LM curve is given by LM2 and the demand side output equilibrium is Y2. Similarly, for
each value of the price level there will be a different aggregate demand equilibrium.
Since a higher price level contracts the real money supply, the output equilibrium is
lower when the price level increases.
Here the price level rises from P1 to P2, and income falls from Y1 to Y2. The aggregate
demand curve in panel (b) plots this negative relationship between national income and
the price level. In other words, the aggregate demand curve shows the set of equilibrium
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points that arise in the IS – LM model as we vary the price level and see what happens
to income. The lower panel of Figure 4.1 shows the equilibrium level of output that
corresponds to each price level. The curve labeled D is a locus of IS-LM, or aggregate
demand, equilibria. It is called the aggregate demand curve because it summarizes
equilibrium on the demand side of the economy.
r LM2
Panel (a)
LM1
IS
Y2 Y1 Y
Panel (b)
P
P1 P2
P1
AD
Y2 Y1 Y
Figure 4.1: The Aggregate Demand Curve
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The negative slope of the total demand curve follows from the derivation shown in
Figure 4.1 and also agrees with one’s intuition. When prices increase, nominal income
also increases and the demand for money to be used for transactions goes up. If the
nominal money supply is unchanged, there will be a shortage of transactions balances.
This “tightness” in financial markets and/or the interest rate increases that will result
restrain aggregate demand. The price increase is equivalent to a tighter money policy
and similarly leads to a fall in the demand for output.
What causes the aggregate demand curve to shift? Because the aggregate demand
curve is merely a summary of results from the IS – LM model, events that shift the IS
curve or the LM curve (for a given price level) cause the aggregate demand curve to shift.
An important point is the distinction between movements along and shifts of the
aggregate demand curve.
The aggregate demand curve in Figure 4.1 is drawn for given values of all the exogenous
variables in the IS-LM model. A change in the level of government expenditure, taxes, or
the nominal money supply will affect the aggregate demand equilibrium for every price
level and thereby affect the position of the aggregate demand curve.
For instance, an increase in the money supply raises income in the IS – LM model for
any given price level; it thus shifts the aggregate demand curve to the right, as shown in
panel (a) of the figure that follows.
Similarly, an increase in government purchases or a decrease in taxes raises income in

the IS – LM model for a given price level; it also shifts the aggregate demand curve to
the right, as shown in panel (b). 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.
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LM1
r
IS2
IS1
P1
AD2
AD1
Figure 4.2: A Shift in Aggregate Demand

Any change in exogenous variables that determines a shift in either the IS or the LM
curve (e.g. fiscal or monetary policy actions, changes in the exogenous components of
aggregate demand or money demand, changes in the parameters) will, under general
conditions, produce a shift in the aggregate demand schedule. The size of the response
of aggregate demand depends on the source of the shock and the characteristics of the
transmission channel.
Let us now derive the aggregate demand (AD) mathematically and examine its
properties. As a first step to this, recall that the IS equation Y = Ca + c(Y – T) + Ia – br + G
can be rewritten as:
------------------------------------------------------ (1).
Similarly, the LM equation M/P = kY – hr can be rewritten as:
---------------------------------------------------------------------------- (2).
We can now substitute equation (1) into equation (2) and solve for the level of Y, the
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equilibrium output in the IS – LM model. We will then see how Y and P are related – the
aggregate demand function we are looking for.
Taking terms involve Y to the left of the equality sign:
The last equation can equivalently be written as:
-------- The AD function!
The slope of the AD function is found as follows:
 From the AD function we derived, we see that: .
 The slope is then the reciprocal of this expression for . That is,
As all the parameters (b, k, h, (1 – c)) and as well as M and P2 are strictly non-negative,
the slope is negative – verifying that the AD curve is downward sloping!
From the AD function we can also infer factors that shift the AD curve. For a given price
level, the AD curve shifts to the right (and upward) for an autonomus increase in Ca, Ia, G
or M, and for an autonomus reduction in T. This fact is clearer from the following partial
derivatives:
and
In summary,
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1. a change in income in the IS – LM model resulting from a change in the price

level represents a movement along the aggregate demand curve.
2. a change in income in the IS – LM model for a fixed price level represents a shift
in the aggregate demand curve.
Section Reflection
 How does the Keynesian approach to macroeconomic fluctuations differ from

that of classicals?
 For a hypothetical closed economy with: C = 50 + 0.75 Yd; I = 100 – 2r; G = 120; T
= 140; Ms = 440; (M/P)d = 0.5Y – 1.5r.
a. Write down the AD function.
b. Discuss the impact of changes in G and changes in MS on the position of the AD
curve you derived in (a).
 How does the sensitivity of investment to the interest rate affect the slope of the
aggregate demand curve?
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SECTION TWO: AGGREGATE SUPPLY
Section Objectives

 undestand what aggregate supply is;
 explain the different approaches/models for estabilishing an upward sloping
aggregate supply;
 discuss what factors cause shifts in the aggregate demand curve;
 realize that the Phillips curve is one way to express aggregate supply; and
 understand the conditions under which a tradeoff exists between inflation and
unemployment.
Section Overview
SECTION TWO: AGGREGATE SUPPLY
2.1 Introduction to Aggregate Supply
2.2 Four Models of Aggregate Supply
2.3 Inflation, Unemployment and the Phillips Curve
2.1 Introduction to Aggregate Supply
The aggregate demand curve describes the amount of output that people are willing to
buy at different price levels. But, the levels of equilibrium output and price that will
actually emerge also depend on supply behavior. We now turn to the determination of
supply behavior and develop different approaches to the aggregate supply curve.
Aggregate supply describes the amount of output that producers are willing and able to
supply to the goods market. Subsequently, we will take a more general view of price
determination and develop an explanation of inflation – the rate of price change.
Most economists analyze short-run fluctuations in aggregate income and the price level
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using the model of aggregate demand and aggregate supply. In the previous section, we
examined aggregate demand in some detail. The IS – LM model shows how changes in
monetary and fiscal policy shift the aggregate demand curve. We now turn our attention
to aggregate supply and develop theories that explain the position and slope of the
aggregate supply curve.
The aggregate supply curve implicit in the Keynesian IS-LM model is based on the notion
that there are no supply constraints and that prices are pre-determined in the short-run.
Thus, whatever output level is demanded will be produced and the aggregate supply
curve is a horizontal line. There is sufficient excess capacity so that an increase in
demand leads to more production without increasing production costs and prices. For
this reason the early Keynesian economists who were schooled by the experiences of
the depression used IS-LM analysis exclusively because they thought in terms of
situations with a great deal of excess productive capacity. In this framework, we can
view the price level as being set by existing contractual arrangements such as union
contracts, sales agreements, and price lists. It is assumed that any level of output can
be supplied at this given level of prices.
At the opposite extreme to the Keynesian short-run horizontal supply curve lies the
supply curve of the classical (or the long-run equilibrium) view of the macroeconomic
world. The classical view implies a vertical supply curve. The classical view of
macroeconomics is rooted in the idea that the macro economy is the aggregate of an
infinite number of perfectly competitive markets. In this view each and every market for
outputs and inputs reaches an equilibrium which determines both the relative price and
the quantity for that market. The level of output supplied is simply the aggregate of all
these outcomes for any overall price level. This is the case because each and every
market-equilibrium determines the relative price of the good in that market. As long as
relative prices stay in equilibrium, the same level of aggregate output will be supplied.
A change in the aggregate price level does not disturb the relative price relationships
between all pairs of goods. Thus, the aggregate supply curve is vertical at this
equilibrium output level no matter what the aggregate price level happens to be. The
vertical classical aggregate supply curve can be understood if we imagine that the
aggregate price level doubles. If every price doubles in terms of the money unit of
account in the economy, the aggregate price level doubles as well. Moreover, no relative
price between pairs of goods changes, and thus the equilibrium level of output supplied
remains unchanged. Therefore, the aggregate supply curve in the classical model is
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vertical.
The classical vertical aggregate supply curve and the Keynesian horizontal aggregate
supply curve represent two theoretical extremes, neither of which is a satisfactory
representation of behavior in the real world. The traditional Keynesian approach leaves
us without a theory of price determination. The classical approach introduces a theory of
price determination, but at the cost of eliminating an explanation of fluctuations in real
output. By assuming that competitive markets at all times generate equilibrium levels of
output, the classical model does away with fluctuations in output.
A more appropriate view of the total supply curve will be the middle road – a positively
sloped aggregate supply curve. Such an approach is relevant for adjustments that occur
for longer periods than the Keynesian short-run period (where quantity adjustments are
dominant) and less than the long run (the period for which the long-run equilibrium
approach is dominant).
In general, 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 affect the price
level, but the output of the economy remains at its natural rate. By contrast, in the short
run, prices are sticky, and the aggregate supply curve is not vertical. In this case, shifts in
aggregate demand do cause fluctuations in output. So far we took a simplified view of
price stickiness by drawing the short-run aggregate supply curve as a horizontal line,
representing the extreme situation in which all prices are fixed. Our task now is to refine
this understanding of short run aggregate supply.
Unfortunately, one fact makes this task more difficult: economists disagree about how
best to explain aggregate supply. As a result, this section begins by presenting four
prominent models of the short-run aggregate supply curve. Among economists, each of
these models has some prominent adherents (as well as some prominent critics), and
you can decide for yourself which you find most plausible. 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 long-run aggregate supply curves
differ and a common conclusion that the short-run aggregate supply curve is upward
sloping.
After examining the models, we examine an implication of the short-run aggregate
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supply curve. We show that this curve implies a tradeoff between two measures of
economic performance – inflation and unemployment. According to this tradeoff, to
reduce the rate of inflation policymakers must temporarily raise unemployment, and to
reduce unemployment they must accept higher inflation. The tradeoff between inflation
and unemployment is only temporary. One goal of this section is to explain why
policymakers face such a tradeoff in the short run and, just as important, why they do
not face it in the long run.
2.2 Four Models of Aggregate Supply
In this subsection we examine four prominent models of aggregate supply, roughly in

the order of their development. In all the models, some market imperfection (that is,
some type of friction) causes the output of the economy to deviate from the classical
benchmark. As a result, the short-run aggregate supply curve is upward sloping, rather
than vertical, and shifts in the aggregate demand curve cause the level of output to
deviate temporarily from the natural rate. These temporary deviations represent the
booms and busts of the business cycle.
Although each of the four models takes us down a different theoretical route, each route
ends up in the same place. That final destination is a short-run aggregate supply
equation of the form:
.
where Y is output, is the natural rate of output, P is the price level, Pe is the expected
price level, and is a positive constant. This equation states that output deviates from
its natural rate when the price level deviates from the expected price level. The
parameter indicates how much output responds to unexpected changes in the price
level (i.e., ). Equivalently, is the slope of the aggregate supply curve (i.e.,
).
Each of the four models tells a 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.
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2.2.1 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 not covered by formal contracts, 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 short run.
The sticky-wage model shows what a sticky nominal wage implies for aggregate supply.
To preview the model, consider what happens to the amount of output produced when
the price level rises:
1) When the nominal wage is stuck, a rise in the price level lowers the real wage,
making labor cheaper.
2) The lower real wage induces firms to hire more labor.
3) The additional labor hired produces more output.
This positive relationship between the price level and the amount of output means that
the aggregate supply curve slopes upward during the time when the 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. The bargaining parties – the workers and the
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: union power and efficiency-wage considerations tend to keep real
wages above the level that brings supply and demand into balance.
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
where W is nominal wage, ω is target real wage rate, and Pe the expected price level.
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:
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The real wage rate is the product of the target real wage rate and the expected to actual
price level ratio.
This 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
e
expected (P /P < 1), the real wage is greater than its target; when the actual price level is
less than expected (Pe/P > 1), 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. In other words, the bargain between the workers
and the firms does not determine the level of employment in advance; instead, the
workers agree to provide as much labor as the firms wish to buy at the predetermined
wage. We describe the firms’ hiring decisions by the labor demand function:
L = Ld (W/P).
According to this labor demand function, the lower the real wage, the more labor firms
hire. The labor demand curve is shown in panel (a) of Figure 4.3 below. Output is
determined by the production function:
Y = F(L),
which states that the more labor is hired, the more output is produced. This is shown in
panel (b) of the figure.
Panel (c) of the figure shows the resulting aggregate supply curve. Because the nominal
wage is sticky, an unexpected change in the price level moves the real wage away from
the target real wage, and this change in the real wage influences the amounts of labor
hired and output produced. The aggregate supply curve can be written as:
.
Output deviates from its natural level when the price level deviates from the expected
price level.
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Figure 4.3: The Sticky Wage Model
2.2.2 The Worker-Misperception Model
This model also explains the up-ward sloping short-run aggregate supply curve by
focusing on the labor market. Unlike the sticky-wage model, however, the worker-
misperception model assumes that wages can adjust freely and quickly to balance the
supply of and demand for labor. Its key assumption is that unexpected movements in
the price level influence labor supply because workers temporarily confuse real and
nominal wages.
The two components of the worker-misperception model are labor supply and labor
demand. As before the quantity of labor firms demand depends on the real wage:
Ld = Ld (W/P).
The labor supply is new:

Ls = Ls (W/Pe).
This equation states that the quantity of labor supplied depends on the real wage that
workers expect to earn. Workers know their nominal wage W, but they do not know the
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overall price level P. When deciding how much to work, they consider the expected real
wage, which equals the nominal wage W divided by their expectations of the price level
Pe.
We can also write the expected real wage as:
The expected real wage is the product of the actual real wage W/P and the variable P/Pe.
Notice that P/Pe measures workers’ misperception of the price level: if P/Pe is greater
than one, the price level is greater than what workers expected, and if P/Pe is less than
one, the price level is less than that expected. To see what determines labor supply, we
can substitute this expression for W/Pe and write:
Ls = Ls [(W/P) X (P/Pe)].
The quantity of labor supplied depends on the real wage and on worker misperception of
the price level.
To see what this model says about aggregate supply, consider the equilibrium in the
labor market, shown in the figure below.
As is usual, the labor demand curve slopes downward, the labor supply curve slopes
upward, and the wage rate adjusts to equilibrate supply and demand. Note that the
position of the labor supply curve and thus the equilibrium in the labor market depend on
worker misperception P/Pe.
Real wage, W/P

Ls = Ls [(W/P) X (P/Pe)]
(W/P)*
Ld = Ld (W/P)
L* Labor, L
Figure 4.4: Labor Supply and Demand under the Worker-Misperception Model
Whenever the price level P rises, the reaction of the economy depends on whether
workers anticipate the change. If they do, then Pe rises proportionately with P. In this
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case workers’ perceptions are accurate, and neither labor supply nor labor demand
changes. The nominal wage rises by the same amount as prices, and the real wage and
the level of employment remain the same.
By contrast, if the price increase catches workers by surprise, then Pe remains the same
when P rises. The increase in P/Pe shifts the labor supply curve to the right, as in Figure
4.5 below, lowering the real wage and raising the level of employment. In essence,
workers believe that the price level is lower, and thus the real wage is higher, than
actually is the case. This misperception induces them to supply more labor. Firms are
assumed to be better informed than workers and to recognize the fall in the real wage,
so they hire more labor and produce more output.
Real wage, W/P L s1
L s2
(W/P)1
(W/P)2
Ld
L1 L2 Labor, L
Figure 4.5: The Worker-Misperception Model
To sum up, the worker-misperception model says that deviations of prices from
expected prices induce workers to alter their supply of labor and that this change in
labor supply alters the quantity of output firms produce. The model implies an aggregate
supply of the form:
.
Once again, as with the sticky-wage model but for different reasons, output deviates
from the natural rate when the price level deviates from the expected price level.
In any model with an unchanging labor demand curve, such as the two models we just
discussed, employment rises when the real wage falls. In these models, an unexpected
rise in the price level lowers the real wage and thereby raises the quantity of labor hired
and the amount of output produced. Thus, the real wage should be countercyclical: it
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should fluctuate in the opposite direction from employment and output. Keynes himself
wrote in The General Theory that “an increase in employment can only occur to the
accompaniment of a decline in the rate of real wages.’’
Yet the real world data (for economies like that of the US) show only a weak correlation
between the real wage and output, and it is the opposite of what Keynes predicted. That
is, if the real wage is cyclical at all, it is slightly procyclical: the real wage tends to rise
when output rises. Abnormally high labor costs cannot explain the low employment and
output observed in recessions.
How should we interpret this evidence? Most economists conclude that the sticky-wage
and the worker-misperception models cannot, by themselves, fully explain aggregate
supply. They advocate models in which the labor demand curve shifts over the business
cycle. These shifts may arise because firms have sticky prices and cannot sell all they
want at those prices; we discuss this possibility later.
2.2.3 The Imperfect-Information Model
The third explanation for the upward slope of the short-run aggregate supply curve is
called the imperfect-information model. Unlike the sticky-wage model (and like the
worker-misperception model), this model assumes that markets clear – that is, all
wages and prices are free to adjust to balance supply and demand. In this model, as in
the worker-misperception 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 prices of what
they produce but less closely the prices of all the goods they consume. Because of
imperfect information, they sometimes confuse changes in the overall level of prices
with changes in 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.
Consider the decision facing a single supplier – a wheat farmer, for instance. Because
the farmer earns income from selling wheat and uses this income to buy goods and
services, the amount of wheat she chooses to produce depends on the price of wheat
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relative to the prices of other goods and services in the economy. If the relative price of
wheat is high, the farmer is motivated to work hard and produce more wheat, because
the reward is great. If the relative price of wheat is low, she prefers to enjoy more leisure
and produce less wheat.
Unfortunately, when the farmer makes her production decision, she does not know the
relative price of wheat. As a wheat producer, she monitors the wheat market closely and
always knows the nominal price of wheat. But she does not know the prices of all the
other goods in the economy. She must, therefore, estimate the relative price of wheat
using the nominal price of wheat and her expectation of the overall price level.
Consider how the farmer responds if all prices in the economy, including the price of
wheat, increase. One possibility is that she expected this change in prices. When she
observes an increase in the price of wheat, her estimate of its relative price is
unchanged. She does not work any harder.
The other possibility is that the farmer did not expect the price level to increase (or to
increase by this much).When she observes the increase in the price of wheat, she is not
sure whether other prices have risen (in which case wheat’s relative price is unchanged)
or whether only the price of wheat has risen (in which case its relative price is
higher).The rational inference is that some of each has happened. In other words, the
farmer infers from the increase in the nominal price of wheat that its relative price has
risen somewhat. She works harder and produces more.
Our wheat farmer is not unique. When the price level rises unexpectedly, all suppliers in
the economy observe increases in the prices of the goods they produce. They all infer,
rationally but mistakenly, that the relative prices of the goods they produce have risen.
They work harder and produce more.
To sum up, the imperfect-information model says that when actual prices exceed
expected prices, suppliers raise their output. The model implies an aggregate supply
curve that is now familiar: . Output deviates from the natural rate
when the price level deviates from the expected price level.
2.2.4 The Sticky-Price Model
Our fourth and final explanation for the upward-sloping short-run aggregate supply curve
is called the sticky-price model. This model emphasizes that firms do not instantly
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adjust the prices they charge in response to changes in demand. Sometimes prices are
set by long-term contracts between firms and customers. Even without 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. Notice that
this model encourages us to depart from the assumption of perfect competition.
Perfectly competitive firms are price takers rather than price setters. If we want to
consider how firms set prices, it is natural to assume that these firms have at least
some monopoly control over the prices they charge.
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:

.
This equation says that the desired price p depends on the overall level of prices P and
on the level of aggregate output relative to the natural rate . The parameter a
(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:
,
where, as before, a superscript “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
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term, , is zero. Then these firms set the price:

.
That is, firms with sticky prices set their prices based on what they expect other firms to
charge.
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:
.
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:
.
Divide both sides by s to solve for the overall price level:
.
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 level 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 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: , where .
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 the price level from the
expected price level.
Although the sticky-price model emphasizes the goods market, consider briefly what is
happening in the labor market. If a firm’s price is stuck in the short run, then a reduction
in aggregate demand reduces the amount that the firm is able to sell. The firm responds
to the drop in sales by reducing its production and its demand for labor. Note the
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contrast to the sticky-wage and worker misperception models: the firm here does not
move along a fixed labor demand curve. Instead, fluctuations in output are associated
with shifts in the labor demand curve. Because of these shifts in labor demand,
employment, production, and the real wage can all move in the same direction. Thus, the
real wage can be procyclical.
We have seen four models of aggregate supply and the market imperfection that each
uses to explain why the short-run aggregate supply curve is upward sloping. Keep in
mind that these models are not incompatible with one another. We need not accept one
model and reject the others. The world may contain all four of these market
imperfections, and all may contribute to the behavior of short-run aggregate supply.
Although the four models of aggregate supply differ in their assumptions and emphases,
their implications for aggregate output are similar. All can be summarized by the
equation:
.
This equation states that deviations of output from the natural rate are related to
deviations of the price level from the expected price level. If the price level is higher than
the expected price level, output exceeds its natural rate. If the price level is lower than
the expected price level, output falls short of its natural rate. The figure below graphs
this equation. Notice that the short-run aggregate supply curve is drawn for a given
expectation Pe and that a change in Pe would shift the curve.
Figure 4.6: The Short Run Aggregate Supply Curve

Now that we have a better understanding of aggregate supply, let’s put aggregate supply
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and aggregate demand back together. The following figure uses our aggregate supply
equation to show how the economy responds to an unexpected increase in aggregate
demand attributable, say, to an unexpected monetary expansion. In the short run, the
equilibrium moves from point A to point 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 , and output rises from Y1 to Y2, which is
above the natural rate . 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 short-run aggregate supply curve to shift upward. As
the expected price level rises from P2e to P3e, 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. In other words, the economy returns to the natural level of output in the long run,
but at a much higher price level.
Figure 4.7: How Shifts in Aggregate Demand Lead to Short-Run Fluctuations
This analysis shows an important principle, which holds for each of the four models of
aggregate supply: long-run monetary neutrality and short-run monetary non-neutrality are
perfectly compatible. Short-run non-neutrality is represented here by the movement from
point A to point B, and long-run monetary neutrality is represented by the movement
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from point A to point C. We reconcile the short-run and long-run effects of money by
emphasizing the adjustment of expectations about the price level.
2.3 Inflation, Unemployment, and the Phillips Curve
Two goals of economic policymakers are low inflation and low unemployment, but
often these goals conflict. Suppose, for instance, that policymakers were to use
monetary or fiscal policy to expand aggregate demand. This policy would move the
economy along the short-run aggregate supply curve to a point of higher output and
a higher price level. (This is shown by the change in equilibrium from point A to point
B in Figure 4.7.) Higher output means lower unemployment, because firms need
more workers when they produce more. Given the previous year’s price level, a higher
price level means higher inflation. Thus, when policymakers move the economy up
along the short-run aggregate supply curve, they reduce the unemployment rate and
raise the inflation rate. Conversely, when they contract aggregate demand and move
the economy down the short-run aggregate supply curve, unemployment rises and
inflation falls.
This tradeoff between inflation and unemployment is called the Phillips curve. The
Phillips curve is a reflection of the short-run aggregate supply curve: as policymakers
move the economy along the short-run aggregate supply curve, unemployment and
inflation move in opposite directions. The Phillips curve is a useful way to express
aggregate supply because inflation and unemployment are such important measures of
economic performance.
2.3.1 Deriving the Phillips Curve from the Aggregate Supply Curve
The Phillips curve in its modern form states that the inflation rate depends on three
forces:
1. Expected inflation ;
2. The deviation of unemployment from the natural rate, called cyclical
unemployment ; and
3. Supply shocks v.
These three forces are expressed in the following equation:
where is a parameter measuring the response of inflation to cyclical unemployment.
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Notice that there is a minus sign before the cyclical unemployment term: high
unemployment tends to reduce inflation. This equation summarizes the relationship
between inflation and unemployment.
From where does this equation for the Phillips curve come? Although it may not
seem familiar, we can derive it from our equation for aggregate supply. To see how,
we will first write the aggregate supply equation as: .
With one addition, one subtraction, and one substitution, we can manipulate this
equation to yield a relationship between inflation and unemployment.
Here are the three steps. First, add to the right-hand side of the equation a supply shock
v to represent exogenous events (such as a change in world oil prices) that alter the
price level and shift the short-run aggregate supply curve:
+ v.
Next, to go from the price level to inflation rates, subtract last year’s price level
P−1 from both sides of the equation to obtain
+ v.
The term on the left-hand side, , is the difference between the current price level
and last year’s price level, which could be taken as inflation ( ). In fact, inflation is (P –
P-1)/P-1, and our decision to take as inflation is for simplicity. (Alternatively, if we
assume that P and P-1 are prices in logarithms, is correct!) The term on the
right-hand side, , is the difference between the expected price level and last
year’s price level, which could similarly be taken as expected inflation . Let us replace
with and with :
Third, to go from output to unemployment, recall that Okun’s law gives a relationship
between these two variables. One version of Okun’s law states that the deviation of
output from its natural rate is inversely related to the deviation of unemployment from
its natural rate; that is, when output is higher than the natural rate of output,
unemployment is lower than the natural rate of unemployment. We can write this as:
=– .
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Using this Okun’s law relationship, we can substitute for in the
previous equation to obtain:
Thus, we can derive the Phillips curve equation from the aggregate supply equation. All
this algebra is meant to show one thing: the Phillips curve equation and the short-run
aggregate supply equation represent essentially the same macroeconomic ideas. In
particular, both equations show a link between real and nominal variables that causes
the classical dichotomy (the theoretical separation of real and nominal variables) to
break down in the short run. According to the short-run aggregate supply equation,
output is related to unexpected movements in the price level. According to the Phillips
curve equation, unemployment is related to unexpected movements in the inflation rate.
The aggregate supply curve is more convenient when we are studying output and the
price level, whereas the Phillips curve is more convenient when we are studying
unemployment and inflation. But we should not lose sight of the fact that the Phillips
curve and the aggregate supply curve are two sides of the same coin.
2.3.2 Adaptive Expectations and the Phillips Curve
To make the Phillips curve useful for analyzing the choices facing policymakers, we
need to say what determines expected inflation. A simple and often plausible
assumption is that people form their expectations of inflation based on recently
observed inflation. This assumption is called adaptive expectations.
For example, suppose that people expect prices to rise this year at the same rate as they
did last year. Then expected inflation equals last year’s inflation :
.
In this case, we can write the Phillips curve as:
,
which states that inflation depends on past inflation, cyclical unemployment, and a
supply shock.
The first term in this form of the Phillips curve, , implies that inflation has inertia.
That is, like an object moving through space, inflation keeps going unless something
acts to stop it. In particular, if unemployment is at the natural rate and if there are no
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supply shocks, the continued rise in price level neither speeds up nor slows down. This
inertia arises because past inflation influences expectations of future inflation and
because these expectations influence the wages and prices that people set. Robert
Solow captured the concept of inflation inertia well when, during the high inflation of the
1970s, he wrote, “Why is our money ever less valuable? Perhaps it is simply that we have
inflation because we expect inflation, and we expect inflation because we’ve had it.’’
In the model of aggregate supply and aggregate demand, inflation inertia is interpreted
as persistent upward shifts in both the aggregate supply curve and the aggregate
demand curve. Consider first aggregate supply. If prices have been rising quickly, people
will expect them to continue to rise quickly. Because the position of the short-run
aggregate supply curve depends on the expected price level, the short-run aggregate
supply curve will shift upward over time. It will continue to shift upward until some event,
such as a recession or a supply shock, changes inflation and thereby changes
expectations of inflation.
The aggregate demand curve must also shift upward to confirm the expectations of
inflation. Most often, the continued rise in aggregate demand is caused by persistent
growth in the money supply. If the central bank suddenly halted money growth,
aggregate demand would stabilize, and the upward shift in aggregate supply would
cause a recession. The high unemployment in the recession would reduce inflation and
expected inflation, causing inflation inertia to subside.
The second and third terms in the Phillips curve equation show the two forces that can
change the rate of inflation. The second term, , shows that cyclical
unemployment – the deviation of unemployment from its natural rate – exerts upward or
downward pressure on inflation. Low unemployment pulls the inflation rate up. This is
called demand-pull inflation because high aggregate demand is responsible for this type
of inflation. High unemployment pulls the inflation rate down. The parameter
measures how responsive inflation is to cyclical unemployment.
The third term (v) shows that inflation also rises and falls because of supply shocks. An
adverse supply shock, such as the rise in world oil prices in the 1970s, implies a positive
value of v and causes inflation to rise. This is called cost-push inflation because adverse
supply shocks are typically events that push up the costs of production. A beneficial
supply shock, such as the oil glut that led to a fall in oil prices in the 1980s, makes v
negative and causes inflation to fall.
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Consider the options the Phillips curve gives to a policymaker who can influence
aggregate demand with monetary or fiscal policy. At any moment, expected inflation and
supply shocks are beyond the policymaker’s immediate control. Yet, by changing
aggregate demand, the policymaker can alter output, unemployment, and inflation. The
policymaker can expand aggregate demand to lower unemployment and raise inflation.
Or the policymaker can depress aggregate demand to raise unemployment and lower
inflation.
The following figure plots the Phillips curve equation and shows the short-run tradeoff
between inflation and unemployment. When unemployment is at its natural rate (u = un),
inflation depends on expected inflation and the supply shock ( ).
Figure 4.8: The Short-Run Phillips Curve
The parameter β determines the slope of the tradeoff between inflation and
unemployment. In the short run, for a given level of expected inflation, policymakers can
manipulate aggregate demand to choose a combination of inflation and unemployment
on this curve, called the short-run Phillips curve.
Notice that the position of the short-run Phillips curve depends on the expected rate of
inflation. If expected inflation rises, the curve shifts upward, and the policymaker’s
tradeoff becomes less favorable: inflation is higher for any level of unemployment. The
figure below shows how the tradeoff depends on expected inflation.
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Figure 4.9: Shifts in Short-Run Phillips Curve

Each Phillips curve is drawn for a given expected rate of inflation. As the expected rate
of inflation changes, the economy moves from one short-run Phillips curve to another.
This means that the combination of the level of unemployment and inflation rate that
occurs depends on the expected inflation rate. When economic agents begin to expect
inflation to continue, the short-run Phillips curve will begin to shift, thereby generating
higher inflation at each given unemployment level. The Friedman-Phelps analysis thus
can explain why the simple Phillips curve of the 1960s seemed to break down in the
1970s and recall that their analysis was made before the Phillips curve began to shift.
The short run Phillips curve shifts with the expected rate of inflation. The inflation rate
corresponding to any given level of unemployment (output) therefore changes over time
as the expected inflation rate changes. The higher the expected inflation rate, the higher
the inflation rate corresponding to any given level of unemployment (output). That is one
important reason why it is possible for the inflation rate and the unemployment rate to
increase together, or for the inflation rate to rise while the level of output falls. The other
important reason is that a supply shock may hit the economy.
On each short-run Phillips curve, the expected inflation rate is constant and except at
points at which , will turn out to be different from the actual inflation rate. If the
inflation rate remains constant for any long period, firms and workers will expect that
rate to continue, and the expected inflation rate will become equal to the actual rate. The
assumption that distinguishes the long-run from the short-run Phillips curve. The
long-run Phillips curve describes the relationship between inflation and
unemployment/output when actual and expected inflation are equal. With the actual and
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expected inflation rates equal Phillips curve shows that . Accordingly, the long-run
Phillips curve is a vertical line joining points on short-run Phillips curves at which the
actual and expected inflation rates are equal.
The meaning of the vertical long-run Phillips curve is that in the long run the level of
unemployment is independent of inflation rate. Note the important contrast between the
short and the long run: in the short run, with a given expected rate of inflation, higher
inflation rates are accompanied by higher output; in the long run, with the expected rate
of inflation equal to the actual rate, the level of unemployment is independent of the
inflation rate.
Because people adjust their expectations of inflation over time, the tradeoff between
inflation and unemployment holds only in the short run. The policymaker cannot keep
inflation above expected inflation (and thus unemployment below its natural rate)
forever. Eventually, expectations adapt to whatever inflation rate the policymaker has
chosen. In the long run, the classical dichotomy holds, unemployment returns to its
natural rate, and there is no tradeoff between inflation and unemployment.
The Phillips curve shows that in the absence of a beneficial supply shock, lowering
inflation requires a period of high unemployment and reduced output. But by how much
and for how long would unemployment need to rise above the natural rate? Before
deciding whether to reduce inflation, policymakers must know how much output would
be lost during the transition to lower inflation. This cost can then be compared with the
benefits of lower inflation.
Much research has used the available data to examine the Phillips curve quantitatively.
The results of these studies are often summarized in a number called the sacrifice ratio,
the percentage of a year’s real GDP that must be forgone to reduce inflation by 1
percentage point. Estimates of the sacrifice ratio vary substantially. If the sacrifice ratio
is estimated to be 5, it means that for every percentage point that inflation is to fall, 5
percent of one year’s GDP must be sacrificed. We can also express the sacrifice ratio in
terms of unemployment. Okun’s law says that a change of 1 percentage point in the
unemployment rate translates into a change of 2 percentage points in GDP. Therefore,
reducing inflation by 1 percentage point requires about 2.5 percentage points of cyclical
unemployment.
We can use the sacrifice ratio to estimate by how much and for how long unemployment
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must rise to reduce inflation. If reducing inflation by 1 percentage point requires a

sacrifice of 5 percent of a year’s GDP, reducing inflation by 4 percentage points requires
a sacrifice of 20 percent of a year’s GDP. Equivalently, this reduction in inflation requires
a sacrifice of 10 percentage points of cyclical unemployment. This disinflation could
take various forms, each totaling the same sacrifice of 20 percent of a year’s GDP. For
example, a rapid disinflation would lower output by 10 percent for 2 years. A moderate
disinflation would lower output by 5 percent for 4 years. An even more gradual
disinflation would depress output by 2 percent for a decade.
2.3.3 Rational Expectations and the Possibility of Painless Disinflation
Because the expectation of inflation influences the short-run tradeoff between inflation
and unemployment, it is crucial to understand how people form expectations. So far, we
have been assuming that expected inflation depends on recently observed inflation.
Although this assumption of adaptive expectations is plausible, it is probably too simple
to apply in all circumstances.
An alternative approach is to assume that people have rational expectations. That is, we
might assume that people optimally use all the available information, including
information about current government policies, to forecast the future. Because
monetary and fiscal policies influence inflation, expected inflation should also depend
on the monetary and fiscal policies in effect.
The rational expectations hypothesis implies that people do not make systematic
mistakes in forming their expectations. Systematic mistakes – for instance, always
under-predicting inflation – are easily spotted. According to the rational expectations
hypothesis, people correct such mistakes and change the way they form expectations.
On average, rational expectations are correct because people understand the
environment in which they operate. Of course people make mistakes from time to time,
but they do not make systematic mistakes.
With expectations formed according to the hypothesis of rationality, there is no trade-off

between unemployment and inflation at all. Unemployment is equal to the natural rate
plus a deviation that is purely random. By the very definition of rationality, there is no
opportunity for the systematic emergence of unanticipated inflation. Only surprises that
are due to random events or an unanticipated policy change can lead to an inflation rate
that differs from the expected rate. Thus the unemployment rate differs from the natural
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rate only when there is a shock or surprise. Furthermore, such deviations must be short-
lived since a surprise cannot last beyond the current period. In the next period it
becomes part of the available information set used by economic agents to determine
rationally. Of course, a shock may appear to persist because its magnitude and
extent were also a surprise.
The natural rate Phillips curve model implies that the unemployment rate differs from
the natural rate when inflation is unanticipated. With rational expectations, unanticipated
inflation is always a random or unpredictable phenomenon. Therefore, all deviations,
including short-run deviations, of the unemployment rate from the natural rate are
random events.
The policy implication of rational expectations can be seen by considering again an

equilibrium disturbed by an expansionary policy. If the policy is known to economic
agents, they will use their knowledge of how such a policy affects the economy. In a
model with a natural rate, an expansionary policy leads to inflation and does not change
the natural rate equilibrium. If expectations are formed rationally, expectations of
inflation will adjust immediately and the new equilibrium will be established immediately.
The immediate adjustment of to all the implications of the policy expansion has
eliminated the distinction between the long-run and short-run response. Hence the policy
ineffectiveness proposition (PIP) of the rational expectations school: In an equilibrium
model, where inflationary expectations are formed rationally, a fully anticipated policy
will have no effect on the level of real economic activity. Put succinctly, we have the
startling and troublesome implication that “policy doesn’t matter.”
If the policy is not fully anticipated, real-sector effects do occur. A policy which surprises
the public can lead to an error in inflation prediction and a deviation of the
unemployment rate from the natural rate. However, such effects must be short-lived
because economic agents will respond and adjust their expectations as soon as the
policy becomes apparent.
It is important to note that the policy ineffectiveness proposition is a consequence of

two elements of the model structure. First, the natural rate Phillips curve indicates that
there is a unique and stable natural unemployment rate. Second, expectations are
formed rationally, with complete knowledge of the underlying equilibrium structure and
all relevant information. If the public is well informed about the economic structure,
economic conditions, and policy goals, it will be able to forecast the inflation rate. That
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makes it impossible to set a policy that makes the unemployment rate differ
systematically from the natural rate.
As long as expectations are an informed forecast which utilize the actual structure of
the economy, the unemployment rate will differ from the natural rate only if there is a
policy surprise. That is, an effective policy must be unanticipated. Only by systematically
fooling the public can policymakers force the unemployment rate to deviate from the
natural equilibrium. There may be some reasons, though, why the public may be fooled
into making errors in forecasting inflation. First, economic agents may have an
imperfect understanding of the workings of the economy; second, their information may
be limited. Policy-makers may have better and more up-to-date information about the
structure of the economy. Besides, policy-makers may be able to fool the public by
pursuing expansionary policy without saying so. Finally, institutional constraints like long
-term labor contracts may imply expectational errors.
Deviations of the unemployment rate persist for much longer periods of time than the
rational expectations hypothesis suggests. Nevertheless, the implications of the rational
expectations Phillips curve are important. The policy ineffectiveness proposition has had
a profound effect on our understanding of what macroeconomic policy can accomplish.
There is an additional lesson to be learned from the new classical approach. It is often
called the policy evaluation or uncertainty proposition. This proposition has very
important real-world implications. The proposition is as follows: In a model where
expectations of inflation are based on all available information and formed with an
understanding of the structure of the economy (i.e., expectations are rational), the
responses of the economy to economic policy initiatives are variable and uncertain.
This proposition is not as unrealistically strong as the policy ineffectiveness proposition.

Nevertheless, it implies that it may be impossible to use discretionary policy to guide the
economy because the implementation of policy alters the responses. According to the
theory of rational expectations, a change in monetary or fiscal policy will change
expectations, and an evaluation of any policy change must incorporate this effect on
expectations.
Advocates of rational expectations argue that the short-run Phillips curve does not
accurately represent the options that policymakers have available. They believe that if
policymakers are credibly committed to reducing inflation, rational people will
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understand the commitment and will quickly lower their expectations of inflation.
Inflation can then come down without a rise in unemployment and fall in output.
If people do form their expectations rationally, then inflation may have less inertia than it
first appears. Accordingly, traditional estimates of the sacrifice ratio (the percentage of
a year’s real GDP that must be forgone to reduce inflation by 1 percentage point) are not
useful for evaluating the impact of alternative policies. Under a credible policy, the costs
of reducing inflation may be much lower than estimates of the sacrifice ratio suggest.
In the most extreme case, one can imagine reducing the rate of inflation without causing
any recession at all. A painless disinflation has two requirements. First, the plan to
reduce inflation must be announced before the workers and firms who set wages and
prices have formed their expectations. Second, the workers and firms must believe the
announcement; otherwise, they will not reduce their expectations of inflation. If both
requirements are met, the announcement will immediately shift the short-run tradeoff
between inflation and unemployment downward, permitting a lower rate of inflation
without higher unemployment.
Although the rational-expectations approach remains controversial, almost all

economists agree that expectations of inflation influence the short-run tradeoff between
inflation and unemployment. The credibility of a policy to reduce inflation is therefore
one determinant of how costly the policy will be. Unfortunately, it is often difficult to
predict whether the public will view the announcement of a new policy as credible. The
central role of expectations makes forecasting the results of alternative policies far
more difficult.
To sum up, if expectations are backward-looking, wages and prices will adjust slowly
over time, so that the Phillips curve has a negative slope. Under rational expectations,
any anticipated change in aggregate demand is incorporated in expectations and wages,
so that, with respect to anticipated changes in demand, the Phillips curve is vertical even
in the short run.
2.3.4 Hysteresis and the Challenge to the Natural-Rate Hypothesis
Our discussion of the cost of disinflation – and indeed our entire discussion of
economic fluctuations – has been based on an assumption called the natural-rate
hypothesis. This hypothesis is summarized in the following statement: Fluctuations in
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aggregate demand affect output and employment only in the short run; in the long run,
the economy returns to the levels of output, employment, and unemployment described
by the classical model. The natural-rate hypothesis allows macroeconomists to study
separately short run and long-run developments in the economy. It is one expression of
the classical dichotomy.
Recently, some economists have challenged the natural-rate hypothesis by suggesting

that aggregate demand may affect output and employment even in the long run. They
have pointed out a number of mechanisms through which recessions might leave
permanent scars on the economy by altering the natural rate of unemployment.
Hysteresis is the term used to describe the long-lasting influence of history on the
natural rate.
A recession can have permanent effects if it changes the people who become
unemployed. For instance, workers might lose valuable job skills when unemployed,
lowering their ability to find a job even after the recession ends. Alternatively, a long
period of unemployment may change an individual’s attitude toward work and reduce his
desire to find employment. In either case, the recession permanently inhibits the process
of job search and raises the amount of frictional unemployment.
Another way in which a recession can permanently affect the economy is by changing
the process that determines wages. Those who become unemployed may lose their
influence on the wage-setting process. Unemployed workers may lose their status as
union members, for example. More generally, some of the insiders in the wage-setting
process become outsiders. If the smaller group of insiders cares more about high real
wages and less about high employment, then the recession may permanently push real
wages further above the equilibrium level and raise the amount of structural
unemployment.
Hysteresis remains a controversial theory. Some economists believe the theory helps
explain persistently high unemployment in Europe, because the rise in European
unemployment starting in the early 1980s coincided with disinflation but continued after
inflation stabilized. Moreover, the increase in unemployment tended to be larger for
those countries that experienced the greatest reductions in inflations, such as Ireland,
Italy, and Spain. Yet there is still no consensus whether the hysteresis phenomenon is
significant, or why it might be more pronounced in some countries than in others. If it is
true, however, the theory is important, because hysteresis greatly increases the cost of
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recessions. Put another way, hysteresis raises the sacrifice ratio, because output is lost
even after the period of disinflation is over.
Section Reflection
 Explain the four theories of aggregate supply. What do they have in common? On
what market imperfection does each theory rely?
 How is the Phillips curve related to aggregate supply?
 Why might cause inflation to have inertia?
 Explain the differences between demand-pull inflation and cost-push inflation.
 Under what circumstances might it be possible to reduce inflation without
causing a recession?
 Explain how a recession might raise the natural rate of unemployment.
UNIT SUMMARY
The crucial difference between the long run and the short run is that prices are flexible in
the long run but sticky in the short run. The model of aggregate demand and aggregate
supply provides a framework to analyze economic fluctuations and see how the impact
of policies varies over different time horizons. The aggregate demand and aggregate
supply model is used to show the determination of the equilibrium levels of both output
and prices.
The aggregate demand schedule, AD, shows at each price level the level of output at
which the goods and assets markets are in equilibrium. This is the quantity of output
demanded at each price level. Along the AD schedule fiscal policy is given, as is the
nominal quantity of money. The AD schedule is derived using the IS-LM model.
Moving down and along the AD schedule, lower prices raise the real value of the money
stock. Equilibrium interest rates fall, and that increases aggregate demand and
equilibrium spending. A fiscal expansion and/or an increase in the nominal money stock
shifts the AD schedule outward and to the right.
The aggregate supply schedule, AS, shows at each level of prices the quantity of real
output firms are willing to supply. The Keynesian supply schedule is horizontal, implying
that firms supply as much goods as are demanded at the existing price level. The
classical supply schedule is vertical. It would apply in an economy that has full price and
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wage flexibility. In such a frictionless economy, employment and output are always at
the full employment level.
Under Keynesian supply conditions, with prices fixed, both monetary and fiscal
expansion raise equilibrium output. A monetary expansion lowers interest rates, while a
fiscal expansion raises them. Under classical supply conditions a fiscal expansion has
no effect on output. But a fiscal expansion raises prices, lowers real balances, and
increases equilibrium interest rates. That is, under classical supply conditions there is
full crowding out. Private spending declines by exactly the increase in government
demand. A monetary expansion, under classical supply conditions, raises prices in the
same proportion as the rise in nominal money. All real variables-specifically, output and
interest rates-remain unchanged. When changes in the money stock have no real effects,
money is said to be neutral.
The four theories of aggregate supply – the sticky-wage, worker-misperception,

imperfect-information, and sticky-price models – attribute deviations of output and
employment from the natural rate to various market imperfections. According to all four
theories, output rises above the natural rate when the price level exceeds the expected
price level, and output falls below the natural rate when the price level is less than the
expected price level.
Economists often express aggregate supply in a relationship called the Phillips curve.
The Phillips curve says that inflation depends on expected inflation, the deviation of
unemployment from its natural rate, and supply shocks. According to the Phillips curve,
policymakers who control aggregate demand face a short-run tradeoff between inflation
and unemployment.
If expected inflation depends on recently observed inflation, then inflation has inertia,
which means that reducing inflation requires either a beneficial supply shock or a period
of high unemployment and reduced output. If people have rational expectations,
however, then a credible announcement of a change in policy might be able to influence
expectations directly and, therefore, reduce inflation without causing a recession.
Most economists accept the natural-rate hypothesis, according to which fluctuations in

aggregate demand have only short-run effects on output and unemployment. Yet some
economists have suggested ways in which recessions can leave permanent scars on the
economy by raising the natural rate of unemployment.
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POST-TEST
1. If a closed economy is in a liquidity trap (a situation where the quantity of money

demand does not respond to a change in interest rate), then the AD schedule is
vertical. True or false? Briefly explain your answer.
2. Changes in government purchases, taxes or money supply shift the aggregate
demand while a change in the price level does not. True or False?
3. The Phillips curve always has a negative slope. True or false? Briefly explain your
answer.
4. Why is the aggregate demand curve downward-sloping?
5. Under what circumstance/s could the aggregate demand curve be horizontal?
6. Suppose the central bank of a country reduces the money supply. Discuss the
impacts of this policy action on:
a. the aggregate demand curve.
b. the level of output and the price level in the short run
c. the level of output and the price level in the long run?
d. unemployment in the short run and in the long run?
REFERENCES
Blanchard, O. (2000). Macroeconomics, 2nd ed. Prentice Hall, Inc.

Branson, W. (1998). Macroeconomic Theory and Practice, 3rd ed.
th
Dornbush, R. and S. Fischer (2002). Macroeconomics, 6 ed. McGraw-Hill.
Mankiw, G. (2004). Macroeconomics, 5th ed. Worth publishers.
Wachtel, P. (1997). Macroeconomics, 4th Printing. The Society of Actuaries.
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UNIT FIVE
OPEN ECONOMY MACROECONOMICS
UNIT OBJECTIVES
After the end of this lesson, the students will be able to:
 Define exchange rate and balance of payment.
 Distinguish between the current account and the capital account.
 Derive the government multiplier, and foreign exchange multiplier.
 Discuss the Marshall- Lerner condition.
 Explain the effect of monetary and fiscal policy in a fixed and flexible
exchange rate for a small country with perfect capital mobility.
UNIT INTRODUCTION
Nowadays the world economies are becoming closely interrelated, and the notion that
we are moving towards a global economy is increasingly accepted. Economic influences
from abroad already have a powerful effect on a given economy. Any economy is linked
to the rest of the world through two broad channels; trade (in goods and services) and
finance. The trade linkage means some of a county’s production is exported to foreign
countries, while some goods that are consumed or invested at home are produced
abroad and imported.
In this unit, we are going to deal with open macroeconomics. We will start our
discussion with exchange rate, exchange rate regimes and alternative exchange rates.
Open economy identities and multipliers are part of the discussion in this unit. Later
open economy macroeconomic policies are covered.
PRE-TEST
 Do you heard about exchange rate and exchange rate regimes? If so, what do
you understand about it? Explain.
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SECTION ONE: EXCHANGE RATES AND EXCHANGE RATE REGIMES
Section objectives

 Define exchange rate
 Compare and contrast the different exchange rate regimes
Section overview
SECTION ONE: EXCHANGE RATES AND

EXCHANGE RATE REGIMES
1.1 Exchange Rate Definitions
1.2 N
ominal, Real and Effective Exchange
1.3 Alternative Exchange Rate Regimes
1.1 Exchange Rate Definitions
The exchange rate is simply the price of one currency in terms of another, and there are
two methods of expressing it:
 domestic currency units per unit of foreign currency- for example USD as the
domestic currency(Birr), on 28 November 2009 there was approximately
12.66 birr required to purchase one USD, that is Birr 12.66/$1.
 foreign currency units per unit of domestic currency-on 28 November 2009
approximately $ 0.08 were required to obtain one Ethiopian Birr, i.e. $0.08/1
Birr.
The spot and forward exchange rates: Foreign exchange dealers not only deal with a
wide variety of currencies but they also have a set of dealing rates for each currency,
which are known as spot and forward rates.
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The spot exchange rate is the quotation between two currencies for immediate delivery.
In other words, the spot exchange rate is the current exchange rates of two currencies
vis-à-vis each other. In practice, there is normally a two-day lag between a spot purchase
or sale and the actual exchange of currencies to allow for verification, paper work and
clearing of payments.
The forward exchange rate- In addition to the spot exchange rate, it is possible for
economic agents to agree today to exchange currencies at some specified time in the
future, most commonly for 1 month, 3months, 6 months, 9 months and 1 year. The rate
of exchange at which such a purchase or sale can be made is known as the forward
exchange rate.
1.2 Nominal, Real and

Effective Exchange Rates
Nominal exchange rate: the exchange rate that prevails at a given date is known as the
nominal exchange rate, and the amount of USD that will be obtained for one Birr in the
foreign exchange market. The nominal exchange rate is merely the price of one currency
in terms of another with no reference made to what this means in terms of purchasing
power of goods/services.
Real exchange rate: the real exchange rate is the nominal exchange rate adjusted for
relative prices between the countries under consideration. The real exchange rate is
normally expressed in index form algebraically as;
Where is the index of the real exchange rate, S is the nominal exchange rate in index
form, P the index of the domestic price level and is the index of the foreign price level.
Effective exchange rate: since most countries of the world do not conduct all their
trade with a single foreign country, policy makers are not so much concerned with what
is happening to their exchange rate against a single foreign currency but rather what is
happening to it against a basket of foreign currencies with which the country trade. The
effective exchange rate as a measure pf whether pr not the currency is appreciating or
depreciating against a weighted basket of foreign currencies. In order to illustrate how
an effective exchange rate is compiled consider a hypothetical case of Ethiopia
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conducting 20% of trade with the China and 80% of its trade with Europe. This means a
weight 0.2 will be attached to the bilateral exchange rate index with the dollar and 0.8 to
the euro.
1.3 Alternative Exchange Rate Regimes
Floating Exchange Rate Regime: Under floating exchange rate regime, the authorities do
not intervene to buy or sell their currency in the foreign exchange market. Rather, they
allow the value of their currency to change due to fluctuations in the supply and demand
of the currency.
In the figure below the exchange rate is initially determined by the interaction of the
demand (D1) and supply (S1) of Birr at the exchange rate of $.08/Birr1. There is an
increase in the demand for Ethiopian exports, which shifts the demand curve from D1 to
D2, and the increase in the demand for Birr leads to an appreciation of the Birr from
$0.08/ birr1 to $1/birr1. Figure b examines the impact of an increase in the supply of Birr
due to an increased demand for US exports and therefore dollars. The increased supply
of birr shift the S1 schedule top the right to S2 resulting in a depreciation of the Birr to
$0.06/birr1. The essence of a floating exchange rate is that the exchange rate adjusts in
response to changes in the supply and demand for a currency.
a) Increase in demand
b) Increase in supply
$/birr
$/birr S1
S
S2
$1.00
$0.08
$0.06
D2
D1 D1
O
O Q1 Q2
Q1 Q2 Quantity
Quantity of of Birr
Birr
Figure 5.1 Floating exchange rate regime
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Fixed exchange rate regime: In figure 5.2 (a) the exchange rate is assumed to be
fixed by the authorities at the point where the demand schedule (D1) intersects the
supply schedule (S1) at $0.08/ birr1. If there is an increase in the demand for birr,
which shifts the schedule from D1 to D2, there is a resulting pressure for the birr to be
revalued. To avert an appreciation it is necessary for the central bank to sell Q1Q2 of
birr to purchase dollars in the foreign exchange market, these purchases shift the
supply of birr from S1 to S2. Such intervention eliminates the excess demand for birr
so that the exchange rate remains fixed at $0.08/ birr1. The intervention increases
the central banks reserves of USD while increasing the amount of birr in circulation.
Figure 5.2 (b) depicts an initial situation where the exchange rate is pegged by the
authorities at the point where the demand schedule (D1) intersects the supply
schedule (S1) at $0.08/ birr1. An increase in the supply of birr (increased demand of
USD) shifts the supply schedule from S1 to S2. The result is an excess supply of birr
at the prevailing exchange rate. This means that there will be pressure for the birr to
be devalued. To avoid this, the national Bank of Ethiopia has to intervene in the
foreign exchange market to purchase Q1Q2 birr to peg the exchange rate. The
intervention is represented by a rightward shift of the demand schedule from D1 to D2.
Such intervention removes the excess supply of birr so that the exchange rate
remains pegged at $0.08/ birr1.
b) Increase in supply
a) Increase in demand
$/birr
S1 S1
$/birr
S2
S2
$0.08 $0.08
D2
D2
D1
D1
Q1 Q2 Quantity
Q1 Q2 Quantity of Birr
of Birr
Figure 5.2 Fixed exchange rate regimes
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 Which one of the above exchange rate regimes exist in Ethiopia? Why?
 What is exchange rate?
 List the different types of exchange rates.
 Distinguish between floating and fixed exchange rate?
 Compare and contrast nominal, real and effective exchange rates.
 What is the difference between forward exchange rate and spot exchange
rate?
PRE-TEST
 Give your own definition of balance of payment
 What components do you expect to be included in the balance of payments?
Why? Give your own explanation.
SECTION 2: THE BALANCE OF PAYMENTS
Section objectives
At the end of this section, students will be able to

 Define balance of payments
 Explain the sub accounts in the balance of payments
Section overview
SECTION 2: THE BALANCE OF PAYMENTS
2.1 Definition
2.2 An Overview of the Sub-Accounts in the Balance of Payments
Definition
The balance of payments is a statistical record of all the economic transactions

between residents of the reporting country and residents of the rest of the world during
a given time period. The usual reporting period for all the statistics included in the
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accounts is a year. Without question balance of payments is one of the most important
statistical statements for any country. It reveals how many goods and services the
country has been exporting and importing and whether the country has been borrowing
from or lending money to the rest of the world. In addition, whether or not the central
monetary authority has been added to or reduced its reserves of foreign currency is
reported in the statistics.
An important point a country’s balance of payments statistics is that in an accounting
sense it always balances. This is because it is based upon the principle of double entry
bookkeeping. Each transaction between a domestic and foreign resident has two sides
to it, a receipt and a payment, and both of these are recorded in the balance of payments
statistics. Each recipient or currency from residents of the rest of the world is recorded
as a credit item (a plus on the accounts), while each payment to residents of the rest of
the world is recorded as a debt (a minus in the account).
Traditionally, the statistics are divided into two main sections- the current account and
the capital account with each part being further sub-divided. The reason for dividing the
balance of payments into these two main parts is that the current account items refer to
income flows, while the capital account records changes in assets and liabilities.
2.2 An Overview of the Sub-Accounts in the Balance of Payments
The trade balance: The trade balance is the sum of the visible trade balance because it
represents the difference between receipts for exports of goods and expenditure on
imports of goods, which can be visibly seen crossing frontier. The receipts for exports
are recorded as a credit in the balance of payments, while the payment for imports is
recorded as a debit. When the trade balance is in surplus this means that country has
earned more from its exports of goods than it has paid for its imports of goods.
The Currents Account Balance: The current account balance is the sum of the visible
trade balance and the invisible balance. The invisible balance shows the difference
between revenue received for exports of services and payments made for imports of
services such as shipping, tourism, insurance, and banking. In addition, receipts and
payments of interest, dividends and profits are recorded in the invisible balance because
they represent the rewards for investment in overseas companies, bonds, and equity,
while payments reflect the rewards to foreign residents for their investment in the
domestic economy. As such, they are receipts and payments for the services of capital
that earn and cost the country income just as do exports and imports.
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Note that there are item referred to as unilateral transfers included in the invisible
balance; these are payments or receipts for which there is no corresponding quid pro
quo. Examples of such transactions are migrant workers’ remittances to their families
back home, the payment of pensions to foreign residents, and foreign aid. Such receipts
and payments represent a redistribution of income between domestic and foreign
residents. Unilateral payments can be viewed as a fall in domestic income due to
payments to foreigners and so are recorded as a debit,
while unilateral receipts can be viewed as an increase in income due to receipts from
foreigners and consequently are recorded as a credit.
The Capital Account Balance: The capital account records transactions concerning the
movement of financial capital into and out of the country. Capital comes into the country
by borrowing, sales of overseas assets and investment in the country by foreigners.
These items are referred to as capital inflows and are recorded as credit items in the
balance of payments. Capital inflows are, in effect, a decrease in the country’s holding of
foreign assets or an increase in liabilities to foreigners. The fact that capital inflows are
recorded as credits in the balance payments often presents students with difficulty. The
easiest way to understand why they are pluses is to think of foreign borrowing as the
export of an IOU. Similarly, investment by foreign residents is the export of equity or
bonds, while sales of overseas investment is an export of those investments to
foreigners. Conversely, capital leaves the country due to lending, buying of overseas
assets and purchases of domestic assets owned by foreign residents. These items are
recorded as debits as they represent the purchase of an IOU from foreigners, the
purchase of foreign bonds or equity and the purchase of investments in the foreign
economy.
Items in the capital account are normally distinguished according to whether they
originate from the private or public sector and whether they are of a shot-term or long-
term nature. The summation of the capital inflows and outflows as recorded in the
capital account gives the capital account balance.
Official Settlements Balance: Given the huge statistical problems involved in compiling
the balance of payments statistics, there will usually be a discrepancy between the sum
all the items recorded in the current account, capital account and the balance of official
financing which in theory should sum to zero. To ensure that the credits and debits are
equal it is necessary to incorporate a statistical discrepancy for any difference between
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the sum of credits and debits. There are several possible sources of this error. One of
the most important is that it is an impossible task to keep track of all the transactions
between domestic and foreign residents; many of the reported statistics are based on
sampling estimates derived from separate sources, so that some error is unavoidable.
Another problem is that the desire to avoid taxes means that some of the transactions in
the capital account are underreported. Moreover, some dishonest firms may deliberately
under-invoice their imports so as to artificially deflate their profits. Another problem is
one of ‘leads and lags’. The balance of payments records receipts and payments for a
transaction between domestic and foreign residents, but it can happen that a good is
imported but the payment delayed. Since the import is recorded by the custom
authorities and the payment by the banks, the time discrepancy may mean that the two
sides of the transaction are not recorded in the same set of figures.
The summation of the current account balance, capital account balance and the
statistical discrepancy gives the official settlements balance. The balance on this
account is important because it shows the money available for adding to the country’s
official reserves or paying off the country’s official borrowing. A central bank normally
holds a stock of reserves made up of foreign currency assets. Such reserves are held
primarily to enable the central bank to purchase its currency should it wish to prevent it
depreciating. Any official settlements deficit has to be covered by the authorities
drawing on the reserves, or borrowing money from foreign central banks or IMF. If, on
the other hand, there is an official settlements surplus this can be reflected by the
government increasing official reserves or repaying debts to the IMF or other sources
overseas (a minus since money leaves the country).
The facts that reserve increases are recorded as a minus, while reserve falls are
recorded as a plus in the balance if payments statistics is usually a source of confusion.
It is the most easily rationalized by thinking that reserves increase when the authorities
have been purchasing the foreign currency because the domestic currency is strong.
This implies that the other items in the balance of payments are in surplus, so reserve
increases have to be recorded as a debit to ensure overall balance. Conversely, reserves
fall when the authorities have been supporting a currency that is weak, that is, all other
items sum to a deficit so reserve falls must be recorded as a plus to ensure overall
balance.
Table 5.1 Summary of balance of payments concepts
Trade balance
+exports of goods
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-imports of goods
= trade balance
Current account balance
Trade balance
+exports of services
+ Interest, dividends and profits received
+ Unilateral receipts
-Import of services
- Interest, dividends and profits paid
- Unilateral payments abroad
= current account balance
Basic balance
+balance on long term capital account
+ Statistical error
= official settlements balance
________________________________________________________________________
 What are the major components of trade balance?
 What is the difference between capital account and current account
balance/? Discuss briefly.
PRE-TEST
 What additional variables do you think are included in the open economy
identities?
SECTION 3: OPEN ECONOMY IDENTITIES AND MULTIPLIERS
Section objectives
At the end of this section, the students will be able to

 Derive open economy multipliers
Section Overview
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Section 3: Open Economy Identities and multipliers
3.1 Some open economy identities

3.2 Open Economy
Multipliers
3.3 The Marshall-Lerner Condition and the J-Curve Effect
Some Open Economy Identities
In an open economy, gross domestic product (GDP) differs from that of a closed
economy because there is an additional injection, export expenditure that represents
foreign expenditure on domestically produced goods. There is also an additional leakage,
expenditure on imports that represents domestic expenditure on foreign goods and
raise foreign national income. The identity for an open economy is given by:
(5.1)
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 T from the right hand side of equation (5.1), we have:
(5.2)
Where Yd is disposable income.

If we denote private savings as S=Yd-C we can rearrange equation (5.2) to obtain;
(5.3)
Where,
Net savings/ dis-savings of the private sector
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Government deficit/surplus
Equation (5.3) is an important identity, it

says that a current account deficit has a counterpart in either private dissaving, that is
private investment exceeding private saving and/or in a government deficit, that is
government deficit that is government expenditure exceeding government taxation
revenue. The equation is merely an identity and says nothing about causation.
Nonetheless, it is of the stated that the current account deficit is due to the lack of
private savings and/or the government budget deficit. However, it is possible that the
causation runs the either way, and it is the current account deficit that may be
responsible for the lack of private savings or budget deficit.
Equation (5.3) can be rearranged to yield

(5.4)
This shows that the equilibrium level of national income is determined where injections
(the variables on the left-hand side of 4.4) are equal to leakages (the variables on the
right-hand side of 4.4). Injections are all those factors that work to lower national
income.
Open Economy Multipliers
The assumptions underlying basic multiplier analysis are:

(i) both domestic prices and the exchange rate are fixed,
(ii) the economy is operating at less than full employment so that increases in
demand result in an expansion of output, and
(iii) The authorities adjust the money supply to changes in money demand by
pegging the domestic interest rate.
This later assumption is important, 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; it is
assumed that the authorities passively expand the money stock to meet any increase in
money demand so that interest rate 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.
The starting point for the analysis is the following identity

(5.5)
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Keynesian analysis proceeds to make assumptions concerning the determinants of the

various components of national income. Government expenditure and exports are
assumed exogenous, government expenditure being determined independently by
political decision, and exports by foreign expenditure decisions and foreign income.
Domestic consumption is partly autonomous and partly determined by the level of
national income. This is denoted algebraically by the equation:
(5.6)
Where is autonomous consumption, is the marginal propensity to consume, that is

the fraction of any increase on income that is spent on consumption. In this simple
model, consumption is assumed a linear function of income. An increase in consumer’s
income induces an increase in their consumption.
Import expenditure is assumed partly autonomous as partly a positive function of the
level of domestic income,
(5.7)
Where 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 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. Since we have assumed that domestic prices are
fixed this means, that income Y also represents real income.
If we substitute equation (5.6) and (5.7) into equation (5.5) we obtain;
Therefore
Given that is equal to the marginal propensity to save, s, that is the fraction of any
increase in income that is saved, then we obtain:
(5.8)
Equation (4.8) can be transformed into difference form yield;
(5.9)
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Where d in front of a variable represents the change in the variable. From equation (4.9),
we can obtain some simple open economy multipliers.
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:
(5.10)
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 the marginal
propensity to save and import 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.
Example
Assume that the marginal propensity to save is 0.25 and the marginal propensity to
import is 0.15. The effect of an increase in government expenditure of $100 million on
national income is given by:
Hence, an increase of government expenditure of $100m will raise eventual national

income by $250m.
The Foreign Trade or Export Multiplier: In this simple model, the multiplier effect of an
increase in exports on national income is identical to that of an increase in government
expenditure, and 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.
Example
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import is 0.15. The effect of an increase in exports of $100 million on national income is
given by:
In the figure below on the vertical axis we have injections/leakages and on the horizontal
axis national income. The savings plus import expenditures (s+m) are assumed to
increase as income rises, reflected by the upward slope of the injections schedule.
Because the sum of the marginal propensity to import and save is less than unity, this
schedule has a slope less than unity. Injections are assumed exogenous of the level of
income and consequently this schedule is a horizontal line. The equilibrium level of
national income is determined where injections into the economy (investment plus
exports) equal leakages (saving and imports), which is initially at income level Y1. An
increase in exports or government expenditure or investment results in an upward shift
of the injections schedule from (G+I+X)1 to (G+I+X)2 and this rise in income induces
more saving and import expenditure but overall the increase in income from Y1 to Y2 is
greater than the initial increase in injections. The lower are the marginal propensities to
save and invest, the less steep the leakages schedule and the greater the increase in
income.
s+
m
(G+I+X)2
(s+m)2
(G+I+X)1
(s+m)1
O
Y1 Y2
Figure 5.3 the government expenditure/ foreign trade

multiplier
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The Current Account Multipliers: The other relationships of interest are the effects of an
increase in government expenditure and of exports on the current account (CA) balance.
Rearranging equation (5.5), we have:
Substituting in equation (4.6) and (4.7) yields:
Since we have:
Multiplying by yields
Adding Ma and X to each side, recalling that M=Ma+mY and rearranging yields:
(5.11)
Equation (4.11) can now be expressed in difference form as:
(5.12)
From the above equation we can derive the effects of an increase in government
expenditure on the current account balance which his 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.
imports is 0.15. The effect of an increase in government expenditure of $100 million on
the current account is given by:
That is, an increase in government expenditure leads to an eventual deterioration in the

current account of $37.5. The reason is that the increased government expenditure of
$100 million because of the open economy multiplier increases national income by
$250m.
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The other multiplier of interest is the effect of an increase in exports on the current
balance.
This is given by the expression:
Since is less than unity, an increase in exports leads to an improvement in the
current 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.
Example
import is 0.15. The effect of an increase in exports of $100 million on the current
account is given by:
The explanation is that the $100 increase in exports initially improves the current
account by a like amount. But it is also generates an eventual increase of national
income of $250 which induces an increase in imports of $37.5m, so the net
improvement in the
The Marshall-Lerner Condition and the J-Curve Effect
The Elasticity Approach to the Balance Of Payments: The elasticity approach to the
balance of payments provides an analysis of what happens to current account
balance when a country devalues its currency. The model focuses on demand
conditions and assumes the supply elasticities for the domestic export good and
foreign import good are perfectly elastic, so that changes in demand volumes have
no effect on prices. In effect, these assumptions mean that domestic and foreign
prices are fixed so that changes in relative prices are caused by changes in the
nominal exchange rate.
The central message of the elasticity approach is that there are two direct effects of a
devaluation on the current balance, one of which works to reduce a deficit, whilst the
other actually contributes to making the deficit worse than before.
The current account balance when expressed in terms of the domestic currency is given
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by:
(5.13)
Where P is the domestic price level, Xv is the volume of domestic exports, S is the
exchange rate (domestic currency units per unit of foreign currency), P* is the foreign
price level and Mv is the volume of imports. We shall set the domestic and foreign price
levels at unity; the value of domestic exports (P Xv) is given by X; while the foreign
currency value of imports (P* Mv) is given by M. using these simplifications equation
(5.13) becomes
(5.14)
In difference form equation (5.14) becomes
(5.15)
Dividing equation (4.15) by the change in the exchange rate dS, we obtain:
(5.16)
At this point we introduce two definitions; the price elasticity of demand for exports ,
is defined as the percentage change in exports over the percentage change in price as
represented by the percentage change in the exchange rate, giving :
So that
(5.17)
And the price elasticity of demand for imports , is defined as the percentage change
in imports over the percentage change on their price as represented by the percentage
change in the exchange rate :
So that,
(5.18)
Substituting (5.17) and (5.18) in to (5.16) we obtain:
And dividing by M
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(5.19)
Assume that we initially have balanced trade, X/SM=1, and rearranging equation (5.19)
yields
(5.20)
Equation (5.20) is the known as the Marshal- Lerner condition and says that starting
from a position of equilibrium in the current account, a devaluation will improve the
current account, that is dCA/dS>0 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 devaluation
will lead to a deterioration of the current account.
3.3.1 Empirical Evidence on Import and Export Demand Elasticities
The possibility that devaluation may lead to a worsening rather than improvement in the
balance of payments led to much research into empirical estimates of the elasticity of
demand for exports and imports. Economists divided 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 ended to
less than unity. It was argued that devaluation may work better for industrialized
countries than developing countries. Many developing countries are heavily dependent
upon imports, and their price elasticity of demand for imports was likely to be very low,
while for industrialized countries that have to face competitive export markets the price
elasticity of demand for their exports may be quite elastic. The implication of the
marshal- Lerner condition was that devaluation may be a cure for some countries
balance of payments deficits but not for others.
There are enormous problems involved in estimating the elasticity of demand for
imports and exports. A summary by Gylfason (1987) of 10 econometric studies
undertaken between 1969 and 1981 has shown that the Marshal-Lerner condition was
fulfilled for all 15 industrial and nine developing countries surveyed. The results are
based on estimated of the elasticities over a two-three-year time horizon. Indeed, a
study by Artus and Knight (1984) has shown that up to a period of six months estimated
price elasticities are invariably so low that the Marshal- Lerner conditions are not fulfilled.
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A consensus accepted by most economists is that elasticities are lower in the short run
than in the long run, in which case the Marshall-Lerner conditions may not hold in the
short run but may hold in the medium to long run. Goldstein and kahn (1985) found that
in general long run elasticities (greater than two years) are approximately twice as great
as short-run elasticities (0-6 months). Further, the short-run elasticities generally fail to
sum to unity, while the long run elasticities almost sum to greater than unity.
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
known as the J-curve effect.
Current
Account
Surplus
O Time
Deficit
Figure 5.4 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 the country receives less export revenue and
spends more on imports leading to deterioration in the current balance. However, after a
time lag export, volumes start to increase and import volumes start to decline, and
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; three of the most important are;
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 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. Switching away from foreign imported goods to
domestically produced goods inevitably takes some time because consumers
will be worried about issues other than the price change, such as the reliability
and reputation of domestic produced goods as compared to the foreign
imports. While foreign consumers may be reluctant to switch away from
domestically produced goods towards the exports of the devaluing country.
 A time lags in producer responses; even though devaluation improves the

competitive position of exports, it will take time for domestic producers to
expand production of exportable. In addition, the orders for imports are
normally made well in advance and such contracts are not readily cancelled in
the short run. Factories will be reluctant to cancel the orders for vital inputs
and raw materials. For example, the waiting list for a Boeing aeroplane can be
over five years; it is most unlikely that the Ethiopian airline will cancel the
order just because the Birr has been devalued.
 Imperfect competition; building up a share of foreign markets can be a time

consuming and costly business. This being the case, foreign exporters may
be very reluctant to lose their market share in the devaluing country and might
respond to the loss in their competitiveness by reducing their exports prices.
To the extent that they do this, the rise in the cost of imports caused by the
devaluation will be partly offset. Similarly, foreign import competing industries
may react to the threat of increased exports by the devaluing country by
reducing prices in their home markets, limiting the amount of additional
exports by the devaluing country. These effects rely upon some degree of
imperfect competition, which gives foreign firms some super normal profit
margins enabling them to reduce their prices. If foreign firms were in a highly
competitive environment they would only be making normal profits and so
would be unable to reduce their prices.
Section reflection/overview
 Define government expenditure multiplier and foreign trade multiplier

 Explain the effect of devaluation on current account.
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 Drive the current account, government multiplier and foreign trade multipliers
and Interpreter your results.
PRETEST
What policy instruments do you expect in an open economy?
SECTION 4: MACROECONOMIC POLICY IN AN OPEN ECONOMY: THE

MUNDELL-FLEMING MODEL
Section objectives
After the end of this section, students will be able to

 Derive the IS, LM, and BP schedule
 Explain the factors that shift the IS, LM, and BP schedule.
Section overview
SECTION 4: MACROECONOMIC POLICY IN AN OPEN ECONOMY: THE MUNDELL-

FLEMING MODEL
4.1 The IS-LM-BP Model
4.2 Factors Affecting the IS-LM-BP Schedule
4.3 A Small Open Economy with Perfect Capital Mobility
4.4 A Small Open Economy with Imperfect Capital Mobility
4.1 The IS-LM-BP Model
Derivation Of the IS Schedule for an Open Economy: The IS curve for an open economy
shows various combinations of the level of output (Y) and the rate of interest that makes
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the leakages, that is savings and import expenditure (S+M), equal to injections, that is
investment, government expenditure and exports (I+G+X). In an open economy, we have
the identity:
Y=C+I+G+X-M (5.21)
Where Y is the national income, C is domestic consumption, I is domestic investment, G
is government expenditure, X is export expenditure and M is import expenditure. This
identity can be restated in terms of equality between leakages and injections. Since
Y-C=S, where S is savings, we can rewrite equation (5.21) as:
S+M=I+G+X (5.22)
For simplicity, the following relationships are assumed:

(5.23)
Here, savings S are equal to autonomous savings plus savings, which are a positive
function of income, where s is the marginal propensity to save.
(5.24)
Imports M are equal to autonomous imports plus imports, which are a positive
function of increase in income, where m is the marginal propensity to import.
(5.25)
Equation (5.25) says that investment is assumed to be an inverse function of the rate of
interest. As far as government expenditure and exports are concerned these are
assumed to be autonomous with respect to the rate of interest and level of national
income,
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Leakage
s (2)
Leakage (1)
s S+M
S+M
L2 L2
L1
L1
Y1 Y2 Income In1 In2 Injections

(I+G+X)
(4) r1 (3)
r1
r2 IS r2
In
Y1 Y2 Income
In1 In2 Injections
(I+G+X)
Figure 5.5 Derivation of the IS
schedule
We know that the income level Y1 generates leakages L1 that will be equal to injections
In1 if the interest rate is r1. This means that in quadrant (4) we can depict point on the IS
curve for an open economy because at interest rate r1 and income level Y1 we know that
leakages are equal to injections. We can repeat the same process for the income level
Y2 to obtain the rate of interest r2 for which leakages are equal to injections. By repeating
the process, we can obtain a large number of income and interest rate levels for which
leakages are equal to injections. By joining up these points we obtain the IS curve for an
open economy. As can be seen in the fourth quadrant the IS curve is downward sloping
from left to right in the interest rate/ income space. This is because higher levels of
income generate higher levels of leakages requiring a fall in the interest rate to generate
increased investment and maintain equality of injections and leakages.
Derivation of the LM Schedule for an Open Economy: The LM schedule shows various
combinations of the level of income and rate of interest for which the money market is
in equilibrium; that is, for which money demand equals money supply. In the simplified
model, we assume that money is demanded for only two reasons; transaction purpose
and speculative purposes. With the transactions, motive people hold money because
there is not normally synchronization between their receipt and expenditure of money. In
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general it is postulated that the higher an individuals income the larger the amount of
money that is held for transactions purposes. This is based on the presumption that the
higher one’s income the greater one’s payments and correspondingly the greater the
desired holdings of money for transaction purposes. As such, the transactions demand
for money is assumed positive function of income. This is expressed algebraically as:
(5.26)
Where is the transaction demand for money.
The other reason for holding money is the speculative motive. It is assumed that any
money balances held in excess of those required for transactions purposes are
speculative balances. If the rate of interest rises then so does the opportunity cost of
holding money. For instance, if the rate of interest is 5% per annum the opportunity cost
of 100 birr is 5 birr per annum, but if the interest rate is 10% the opportunity cost is 10
birr per annum and consequently the demand to hold speculative balances will fall as
the rate of interest rises. This inverse relationship between the demand for speculative
balances and the rate of interest is expressed algebraically as
(5.27)
Where is the speculative demand for money.
In equilibrium, the money demand made up of transactions and speculative
balances equal to the money supply . This is expressed algebraically
The derivation of the LM curve is illustrated in figure 4.6
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Mt
Mt a
(2)
Mt2 Mt2
(1)
Mt1 Mt1
Y1 Y2 Income Msp2 Msp1 a Msp
LM
(3)
r2 r2
(4)
r1 r1
Msp
Y1 Y2 Income
Msp2 Msp1 Msp
Figure 5.6 Derivation of the LM
schedule
Quadrant 1 depicts the transaction demand for money as a positive function of income.
As income rises from Y1 to Y2, the demand for transaction balances rises from Mt1 to Mt2.
the transactions balance figure is transferred to quadrant 2, which shows the
distribution of the fixed money supply between transaction and speculative balances.
The distance Oa represents the total money supply, so that if Mt1 is held for transaction
purpose, then Oa minus Mt1 which is equal to Msp1 is held as a speculative balance.
Quadrant 3 shows the speculative demand for money schedule, which is downward
sloping from left to right because the demand for speculative balances is inversely
related to the rate of interest. The schedule reveals that speculative balances Msp1 are
only willingly held at the interest rate r1. We now have enough information to plot a point
on the LM schedule; this is done in quadrant 4 which shows that at interest rate r1 and
income level Y1 the demand for speculative and transaction balances is equal to the
money supply.
By taking another income level Y2, we can by a similar process find a rate of interest r2,
which is compatible with money-market equilibrium. Other such derivatives can be done
and by joining them together, we obtain the LM schedule. The LM schedule is upward
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sloping from left to right. This is because high income levels require relatively large
transaction balances which for a given money supply can only be drawn out of
speculative balances by a relatively high interest rate.
Derivation of the BP Schedule for an Open Economy: The balance of payments schedule
shows different combination of rates of interest and income that are compatible with
equilibrium in the balance of payments. When referring to the balance of payments we
divide it up into two sections; the current account and the capital account. Exports are
assumed independent of the level of national income and the rate of interest, but
imports are assumed to be positively related to income, expressed as:
(5.28)
Total imports (M) are a function of autonomous imports (Ma) and the level of income,
where m is the marginal propensity to import. The overall balance of payments is made
up of three major components, the current account (CA), the capital account (K) and the
change in the authorities’ reserves (dR). By maintaining balance in the 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 reserves. 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 payments.
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 or 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 (r*) 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:
(5.29)
Since balance of payments schedule shows various combinations of the levels of

income and the rate of interest for which the balance of payments in equilibrium then:
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A positive K indicates a net inflow of funds, whereas a negative K indicates a net

outflow of funds.
Current
account Current
surplus accoun (2)
CA (1) t
CA1 surplus
CA1
O O
CA2 CA2
Deficit
Deficit 450
Y1 Y2 Inflow K2 K1
Incom O Outflow
e capital
account
r
r BP
(4) (3)
r2 r2
r1
r1 K
Y1 Y2 K2 K1
Incom inflow O Outflow
e capital
Figure 5.7 Derivation of the BP account
schedule
Quadrant 1 shows the relationship between the current account and level of national
income. The current balances schedule slopes downwards from left to right because
increase in income lead to 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 current
account deficit of CA2. The current account surplus or deficit is transferred to quadrant 2
where the 45-degree line converts the current account position to an equal capital flow
of the opposite sign. With a current account surplus CA1 there is a required capital
outflow K1 to ensure balance of payments equilibrium, while a current account deficit
CA2 requires a capital inflow K2. Quadrant 3 shows the rate of interest that is required for
a given capital outflow. The capital flow schedule is downward sloping from left to right
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.
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Since income level Y1 is associated with a balance of payments surplus, there has to be
an offsetting capital outflow K1 that 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 a deterioration in the current account,
which 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. At points
to the left of the BP schedule, the overall balance of payments is in surplus because for
a given amount of capital flows the current account is better than that required for
equilibrium, as the level of income is lower. Conversely, to the right of the BP schedule
the overall balance of payments is in deficit as the income level is higher than that
compatible with overall 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.
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
rate 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 will fall 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 capital is imperfectly mobile.
Equilibrium of the model: As we can see in the figure below, all three schedules intersect
through a common point. The BP schedule is steeper than the LM schedule, but this
need not always be the case. Changing the relative slope of the two schedules can lead
to somewhat different policy prescriptions. All three schedules pass through a common
point A which corresponds to the domestic interest rate r1 and income level Y1. The
income level Y1 is seen to be less than that of the full employment level of income Yf,
implying that there is some unemployment in the economy. Although the economy is not
in internal equilibrium, the balance of payments is in equilibrium because the IS and LM
schedule intersect at a point on the BP schedule.
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The explanation as to why the IS-LM schedules do not intersect at the full employment
level of income Yf is that at Yf planned leakages ( savings and import expenditure)
would exceed planned injections ( government expenditure, exports and investment).
This would imply a build up of stocks of unsold goods leading producers to reduce
output. Only at output level Y1 do planned leakages equal planned injections so that
changes in stocks are avoided.
r BP
LM
A
r1
IS
Y1 Yf Y
Figure 5.8 Equilibrium of the model
4.2 Factors Affecting the IS-LM-BP Schedule
Factors Shifting the IS Schedule: The IS schedule will shift to the right if there is an
increase in investment, government expenditure or exports. This is because an increase
in these injections requires a higher level of national income to induce a matching
increase in leakages in the form of increased savings and imports. An autonomous fall
in savings or imports will also require to induce a rightward shift of the IS schedule
because a higher level of income is required to induce more savings and import
expenditure so as to maintain equality of lineages and injections. Another important
factor that causes a rightward shift of the IS schedule is a depreciation or devaluation of
the exchange rate, providing that the Marshall- Lerner condition holds; this is because a
depreciation(rise) in the exchange rate leads to a reduction of import expenditure and an
increase in export sales so that injections then exceed leakages requiring an increased
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level of income to bring them back into equality.
Factors Shifting the LM Schedule: The LM schedule will shift to the right if there is an
increase in the domestic money supply because, for a given rate of interest, the
increased supply will only be willingly held if there is an increase in income, which leads
to a rise in the transactions demand for money. A depreciation of the exchange rate will
lead to a rise in the aggregate price index, that is an index made up of a weighted basket
of domestic and foreign imported goods, because it implies a rise in the price of imports.
This means that real money balances will be reduced and there will be a resulting
increase in the demand for money that can only be eliminated by reducing the
transactions demand for money implying a lower level of income and leftward shift of
the LM schedule.
Factors Shifting the BP Schedule: An autonomous increase in exports or an autonomous

decrease in imports will lead to an improvement in the current account requiring a
rightward shift of the BP schedule to induce a sufficient increase in imports to maintain
balance of payments equilibrium. Another factor that can cause a rightward shift of the
BP schedule is a depreciation/devaluation of the exchange rate, providing the Marshall-
Lerner condition holds; the value of export sales will rise and the value of import
expenditure decline. Hence, the only way to ensure overall balance of payments
equilibrium is a rise in the level of domestic income.
Authorities generally need as many instruments as they have targets and revealed that
the use of both expenditure switching and expenditure changing policies can lead to the
attainment of internal and external balance.
However, it was not possible to distinguish between the fact that fiscal and monetary
policies are quite different and independent types of expenditure changing policies. This
begs the question as to whether or not it is feasible to achieve the twin objectives of
internal and external balance by combining fiscal and monetary policies without the
need to adjust the exchange rate?
Monetary policy: When authorities conduct an expansionary monetary policy they

purchase bonds from the public, which pushes up the price of bonds, expands the
money supply and leads to a fall in the domestic interest rate. The fall in the domestic’s
interest rate will stimulate investment and so lead to a rise in output. As far as the
balance of payments is concerned, the increased income leads to a deterioration of the
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current account and the lower the interest rate will lead to increased capital outflows so
that the balance of payments moves into deficit. Conversely, a concretionary monetary
policy involves that authorities selling bonds, which pushes down the price of binds,
reduces the money supply and leads to a rise in the domestic interest rate. The rise in
the interest rate leads to less investment and a fall in output. The balance of payments
position will improve as imports fall and the higher interest rate attracts capital inflows.
Fiscal policy: With an expansionary fiscal policy, the government increases its
expenditure and with pure fiscal policy finances this increased expenditure by selling
bonds. The increased expenditure shifts the IS schedule to the right through the
government expenditure multiplier effect. However, the bond sales will depress the price
of bonds thereby raising the domestic interest rate, which will partially offset expansion
in output. The precise effect of the fiscal expansion of output will worsen the current
account; the rise in interest rates will improve the capital account. The converse
reasoning holds for a contractionary fiscal policy. The money supply is nit affected by
the expansionary fiscal policy since the money raised by the bond sales is used to
finance the increased government expenditure.
Sterilized and non-sterilized intervention: One other policy, which we need to clarify, is
the distinction between sterilized and non-sterilized intervention in the foreign exchange
market. With sterilized intervention, the authorities offset the money-base implications
of their exchange market interventions to ensure that the changes in reserves due to
intervention do not affect the domestic money base. Whereas with a policy of non-
sterilized intervention the authorities allow the reserve changes resulting from their
interventions to affect the monetary base.
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BP LM1
r
LM2
r1
r2
IS
Y1 Y2 Y
Figure 5.9 a monetary expansion under fixed exchange

rates
A monetary expansion shifts the LM schedule to the right from LM1 to LM2. This causes
a fall in the interest rate to r2 and a rise in domestic income to Y2, the result is a balance
of payments deficit as both the current and capital account deteriorate. The deficit
means that there is an excess supply of the currency on the foreign exchange market
and to maintain a fixed exchange rate the authorities have to purchase the home
currency with reserves.
The purchases of the homecurrency by the authorities would start to shift the LM
schedule back to the left from LM2. This is an example of non-sterilized intervention that
is the authorities allow their interventions in the foreign exchange market to influence
the money supply. However, if the authorities pursue a policy of sterilization of reserve
changes, the reserve falls which reduce the money supply are exactly offset by a further
expansion of the money supply so that the LM schedule remains at point LM2. A clear
problem with a sterilization policy is that by remaining at LM2 with interest rate r2 and
income level Y2, the authorities will suffer a continuous balance of payments deficit and
a continuous fall in reserves. Such a sterilization policy is only feasible in the short run
because over the longer run reserves would eventually run out making devaluation
inevitable.
.
4.3 A Small Open Economy with Perfect Capital Mobility
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After Second World War, there is an increasing integration of the international capital
markets. Mundell (1962) and Fleming (1962) sought to examine the implications of high
capital mobility for a small country that had no ability to influence world interest rates.
They showed that for such a country the choice of exchange rate regime would have a
radical implication concerning the effectiveness of monetary and fiscal policy in
influencing the level of economic activity.
4.3.1 Assumptions of the model
The model assumes a small country facing perfect capital mobility. Any attempt to raise
the domestic interest rate leads to a massive capital inflow to purchase domestic bonds
pushing up the price of bonds until the interest rate returns to the world interest rate.
Conversely, any attempt to lower the domestic interest rate leads to a massive capital
outflows international investors seek higher world interest rates. Such massive bond
sales mean that the domestic interest rate immediately returns to the world interest rate
to stop the capital outflow. The implication of perfect capital mobility is that the BP
schedule for a small open economy becomes a horizontal, straight line at a domestic
interest rate that is the same as the world interest rate.
4.3.2 Fixed Exchange Rate and Perfect Capital Mobility
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LM1
r
LM2
BP
r1
IS2
IS1
O Y
Y1 Y2
Figure 5.10 Fixed exchange rates and perfect capital

mobility
The above figure depicts a small open economy with a fixed exchange rate; the initial
level of income is where the IS-LM curve intersects at the income level Y1 that is below
the full employment level of income Yf. If the authorities attempt to raise output by a
monetary expansion, the LM schedule shifts to the right from LM1 to LM2. There is a
downward pressure on the domestic interest rate and this result in a massive capital
outflow. This capital outflow means that there is pressure for devaluation of the
currency; 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. The purchases have to continue until the LM curve
shifts back to its original position at LM1 where the domestic interest rate is restored to
the world interest rate. With perfect capital mobility, any attempt to pursue a sterilization
policy leads to such large reserve losses that it cannot be pursued. Hence, with perfect
capital mobility and fixed exchange rates monetary policy is ineffective at influencing
output.
By contrast, if there is a fiscal expansion this shifts the IS schedule to the right from IS1
to IS2, which puts upward pressure on the domestic interest rate and leads to a massive
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 agent’s increases and the LM1 schedule shifts to the right from LM1 to LM2.
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The increase in the money stock continues until the LM schedule passes through the IS2
schedule 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.
4.3.3 Floating Exchange Rates and Perfect Capital Mobility
In the following figure, initial equilibrium is at the income level Y1 where the IS1 schedule
intersects the LM1 schedule. In this case, we have a floating exchange rate. A monetary
expansion shifts the LM schedule from LM1 to LM2 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 schedule to the left, so that final equilibrium is obtained at a higher level
of income, say Y2. Clearly, with an appropriate initial monetary expansion the authority’s
initial monetary expansion the authorities could obtain both internal and external
balance by monetary policy alone.
IS2
r LM1
LM3
IS1 LM2
BP
r1
Y
Y1 Y2
Figure 5.11 Floating exchange rates and perfect capital

mobility
Suppose the authorities attempt to expand output by an expansionary fiscal policy. The
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increased government expenditure shifts the IS schedule to the right from IS1 to IS2, but
the bond sales that finance the expansion lead 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
increase in imports, which forces the IS schedule back to its original position. Hence,
with floating exchange rates and perfect capital mobility fiscal policy is ineffective at
influencing real output.
By contrast, a monetary expansion that shifts the LM schedule from LM1 to LM2 leads to
a fall in the domestic interest rate and a depreciation of the exchange rate. This
depreciation then leads to an increase in exports and reduction in imports that shifts the
IS schedule to the right from IS1 to IS2 and some reduction of the real money stock
shifting LM2 to the left to LM3 so that overall income rises to Y2. In this instance, it is
monetary policy alone, which can achieve both internal and external balance, although
the exchange rate adjusts passively to the change in the money stock.
The contrast between the effectiveness of fiscal and monetary policy with perfect
capital mobility under different exchange rate regimes is one of the most famous results
of international economics. Monetary policy is ineffective at influencing output under
fixed exchange rates, while it alone is effective at influencing output under a fixed
exchange rate, while it is ineffective under floating exchange rates.
4.4 A Small Open Economy with Imperfect Capital Mobility
4.4.1 Internal and external balance under fixed exchange rate

A situation of fixed exchange rates and unemployment is depicted in figure 5.12. The
economy is assumed to be at point A whit interest rate r1 and income level Y1, which
means that while the economy is in external balance the income level is below the full
employment level of income Yf.
The government attempts to eradicate the unemployment via a bond financed fiscal
expansion, which shifts the IS schedule to the right from IS1 to IS2. Domestic output
expands from Y1 to Y2 and the economy would be at point B with interest rate r2. In
raising the level of output beyond the full employment level, we find that the induced
increase in imports moves the current account into deficit, and although the rise in the
interest rate attracts some capital inflow the balance of payments is in overall deficit
since the economy is to the right of the BP schedule. The authorities are forced to
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purchase the home currency in the foreign exchange market, but because they pursue a
sterilization policy the LM schedule remains at LM1. Hence, using only a single policy
instrument, in this case fiscal policy, the government can temporarily achieve its internal
objective at the expense of a sacrifice in the objective of external balance.
BP
LM2
C
LM1
r3
B
r2
A
r1
IS2
IS1
Y1 Y
Yf Y2
Figure 5.12 internal and external balances under a fixed

exchange rate
Ideally, however, the authorities would like to achieve both internal and external balance.
This is possible if they combine the expansionary fiscal policy-IS1 to IS2-with a
contractionary monetary policy which shifts the LM schedule from LM1 to LM2 where it
passes through point C on the BP schedule. The restrictive monetary policy raises
interest rates further than in the case of a solely fiscal expansion to r3, and in so doing
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attracts additional capital inflows so as to restore the balance of payments back to

equilibrium. Hence, by combining an expansionary fiscal policy with a contractionary
monetary policy the authorities can achieve both internal and external balance. An
important lesson from this example is that the authorities can achieve both internal and
external balance without the need to change the exchange rate; this is because they
have two independent instruments, monetary and fiscal policy, and two targets.
4.4.2 Internal and external balance under floating exchange rates
Monetary expansion under floating exchange rates: From figure 5.13 initial equilibrium is
at point A with interest rate r1 and output level Y1. The authorities adopt an expansionary
monetary policy and this shifts the LM schedule from LM1 t o LM2. The combination of a
fall in the interest rate and increase in income leads to a balance of payments deficit at
point B. however, the exchange rate is allowed to depreciate and this leads to a
rightward shift of the IS schedule from IS1 to IS2, and a rightward shift of BP schedule
from BP1 to BP2. However, it also leads to a leftward shift of the LM schedule until all
three schedules intersect at a common point such as C, with new income level Y2 and
interest rate r2. Hence, by using monetary policy in conjunction with exchange rate
changes, it is possible to raise real output to the full employment level and achieves
external balance simultaneously.
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r
BP1
BP2
LM1
LM3
A
r2
C
LM2
r1
B
IS2
IS1
Y1 Y2 Y
Figure 5.13 A monetary expansion under floating exchange

rates
Overall, the money supply expansion results in an exchange rate depreciation, a fall in
the domestic interest rate and an increase in income. The lower the interest rate implies
a lower capital inflow/higher capital outflow than before the money supply expansion,
while the increase in income worsens the current account. This implies that the
depreciation improves the current account to exactly offset the preceding effect.
Fiscal expansion under floating exchange rates: The effects of a fiscal expansion on the
exchange rate under floating rates depend crucially upon the slope of the BP schedule
relative to the LM schedule. We shall consider two cases, in case one the BP schedule is
steeper than the LM schedule, while in case 2 the reverse is true.
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BP1
BP 2
LM2
C
r2 LM1
B
A
IS3
r1
IS2
IS1
Y1 Y2 Y
Figure 5.14 case 1: a fiscal expansion under floating

exchange rates
In the above figure 5.14, the BP schedule is steeper than the LM schedule, which means
that capital outflows are relatively insensitive to interest rate changes, while money
demand is fairly elastic with respect to the interest rate. An expansionary fiscal policy
shifts the IS schedule from IS1 to IS2. the induced rise of the domestic interest rate and
domestic income has opposing effects on the balance of payments, the expansion in
real output leads to a deterioration of the current account but the rise in interest rate
improves the capital account. However, because capital flows are relatively immobile
the former effect outweighs the latter so the balance of payments moves into deficit. In
turn, the deficit leads to a depreciation of the exchange rate, this has the effect of
shifting the BP schedule to the right from BP1 to BP2 and the LM schedule to the left
from LM1 to LM2 and the IS schedule even further to the right from IS2 to IS3 .final
equilibrium is obtained at point C, with interest rate r2 and income level Y2. Hence, the
deterioration in the balance of payments resulting from the rise in real income is offset
by a combination of a higher interest rate and an exchange rate depreciation.
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r
LM1
LM 2
B BP2
r2 C BP1
A
IS2
r1
IS3
IS1
Y1 Y2
Y
Figure 5.15 case 2: a fiscal expansion under floating

exchange rate
In the above figure and expansionary fiscal policy shifts the IS schedule from IS1 to IS2.
In this case, because capital flows are much more responsive to changes in interest
rates the BP schedule is less steep than the LM schedule. The increased capital inflow
more than offsets the deterioration in the current account due to the increase in income,
and the balance of payments moves into surplus. The surplus induces an appreciation
of exchange rate, which moves the LM schedule to the right from LM1 to LM2, the BP
schedule to the left from BP1 to BP2 and the IS schedule to the left from IS2 to IS3.
Equilibrium is obtained at a higher level of output, higher interest rate and an exchange
rate appreciation.
Hence, a fiscal expansion can, according to the degree of international capital mobility,
lead to either an exchange rate depreciation of an exchange rate appreciation.
 Discuss the effect of expansionary monetary and fiscal policy on output in an
open economy with perfect capital mobility. Support your answer with the
appropriate geometry.
 Explain the effect of expansionary fiscal policy under floating exchange rate in
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imperfect capital mobility in an open economy.

 What factors do you think shift the IS, LM, and BP schedules?
 Given the open economy identities derive the government expenditure
multiplier and trade multiplier
UNIT SUMMARY
1. Exchange rate is the price of one currency to another. It can be expressed in

nominal, real or in effective terms. There are two types of exchange rate regimes.
The fixed and floating exchange rate regimes.
2. Balance of payment includes trade balance, current account balance, capital
account balance and official settlement balance.
3. From the open economy identities, it is possible to construct the government
expenditure multiplier, the current account multiplier, and trade multiplier.
4. The effect of devaluation on current account in the short run is different from its
effect in the long run. According to empirical findings, the effect of devaluation in
the short run is negative while it is positive in the long run. That is in the short run
the Marshall- Lerner condition fails to be fulfilled.
5. The Mundell- Fleming model explains the effect of policy change in different
exchange rate regime in the perfect capital mobility and imperfect capital
mobility scenario.
POST-TEST
Discussion Questions
1) Using an appropriate geometric argument, explain the impact of an expansionary
monetary policy and fiscal policy on real income and the exchange rate of a small, open
economy with a flexible exchange rate and perfect capital mobility. What change in the
exchange rate would you expect and why?
2) Differentiate between fixed and flexible exchange rate. Support your answer with
appropriate diagram.
3) discuss the effect of devaluation on the current account in the short run and in the
long run. What are the reasons for the slow responsiveness of export and import
volumes in the short run and why responses are greater in the long run?
4) Derive the IS-LM-BP schedule. Support your answer with the appropriate graph. Find
the equilibrium of the model.
5) Discus the factors that shift the IS, LM, and BP schedule.
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REFERENCES

Mankiw, G. (2000) Macroeconomics, 3rd Ed.
Dornbusch R, and Fischer S., (1994) Macroeconomics, 2nd Ed.
Pentecost, E. (2000) Macroeconomics; an open economy approach.
Pilbeam, K. (1998) International Finance, 2nd Ed.
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Macro Economics-I Module

Introduction to Macroeconomics (Addis Ababa University)

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UNIT ONE: OVERVIEW: DEFINITION, FOCUS AREAS AND INSTRUMENTS OF

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UNIT THREE: MACROECONOMIC FLUCTUATIONS: THE IS-LM APPROACH 36

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After studying this chapter, students will be able to:

Macroeconomics is concerned with the behavior of the economy as a whole- with

The difference between microeconomics and macroeconomics is primarily one of

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theory is the existence of an established orthodoxy, which is clearly inconsistent

SECTION ONE: DEFINITION AND FOCUS AREAS OF

After studying this section, students will be able to:

1.2 Definition of Macroeconomics

Macroeconomics is concerned with the structure, performance and behavior of the

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unemployment, inflation and international transactions. In particular,

1.1 Focus areas of Macroeconomics

Macroeconomics focuses on the economic behavior and policies that affect

It is difficult to overstate just how important satisfactory macroeconomic

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 What are the objectives of macroeconomics?

SECTION TWO: THE STATE OF MACROECONOMICS

After studying this section, students will be able to:

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SECTION TWO: THE STATE OF

2.1 Evolution and Recent Developments

2.2 The Classical and Neoclassical

2.3 The Keynesian Macroeconomics School

2.4 The New Classical Macroeconomics School

2.5 The New Keynesian Macroeconomics

2.1 Evolution and Recent Developments

The Great Depression gave birth to modern macroeconomics as surely as

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Although it is important to remember that economists before Keynes discussed

2.2 The Classical and Neoclassical Macroeconomics School

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2.3 The Keynesian Macroeconomics School

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 The economy is inherently unstable and is subject to erratic shocks. These

2.4 The New Classical Macroeconomics School

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The assumption of market clearing, which implies perfectly and instantaneously

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things worse by intervening. Their approach is a challenge to traditional

One dramatic implication of these assumptions, which seem so reasonable

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2.5 The New Keynesian Macroeconomics School

The new classical school group remains highly influential in today's

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Section reflection/ review

 What is classical and neoclassical macroeconomics?

1. Macroeconomics is the study of the economy as whole-including GDP growth,

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Oranges 2002 Quantity of Oranges).