INTRODUCTION TO ECONOMICS

Arba Minch University

College of Business and Economics
Department of Economics

11/14/2022 1
 CHAPTER SIX
Fundamental Concepts of Macroeconomics

 What dose mean macroeconomics?

 Macroeconomics, studies about overall or aggregate behavior of the
economy.
 such as economic growth, employment, inflation, distribution of
income, macroeconomic policies and international trade.
6.1. Goals of macroeconomics
 Macroeconomics studies the working of an economy in aggregation
or as a whole. it aimed as follow;
 To achieve high economic growth
 To reduce unemployment
 To attain stable prices
 Cont’d
 To reduce budget deficit and balance of payment (BoP) deficit
 To ensure fair distribution of income

 In other words, the goals of macroeconomics can be given as ways

towards full employment, price stability, economic growth and fair
distribution of income among citizens of a country.

6.2. The National Income Accounting

 (NIA) is an accounting record of the level of economic activities of
an economy.
 It is a measure of an aggregate output, income and expenditure in
an economy.
 Cont’d …

Why do we need NIA?

 It enables us to measure the level of total output in a given
period of time, and to explain the causes for such level of
performance.
 Measure of Economic Growth
 Significance for Economic Analysis
 Comparison with other Countries
 It enables us to observe the long run trend of the economy
 It provides information to formulate policies and design plans.
 Indicator of Economic Progress
etc.……………… 4
6.2.1. Approaches to measure national income (GDP/GNP).
Before discussing different approaches of national income, it is
important to understand about (GDP/GNP) .
Gross Domestic Product (GDP):is the market value of all the final
goods and services produced within the domestic territory of a
country during a year.
It is the total value of currently produced final goods and services
that are produced within a country‘s boundary during a given period
of time, usually one year.
From this definition, we can infer that:
It measures the current production only
It takes in to account final goods and services only
we do not include the intermediate products in our GDP
calculations. 5
 Cont’d …
 Intermediate goods are goods that are completely used up in the
production of other products in the same period that they them
selves are produced.
 It measures the values of final goods and services produced within
the boundary/territory of a country.
 In measuring GDP, we take the market values of goods and services

 Where: Pi = series of prices of outputs produced in different sectors

of an economy in certain period
 Qi = the quantity of various final goods and services produced in an
economy.
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 Cont’d …
 Gross National Product (GNP): is the total value of final goods
and services currently produced by domestically owned factors of
production in a given period of time, usually one year, irrespective
of their geographical locations.
 It is the money value of all final goods and services produced in the
domestic territory of a country during a year plus net-factor income
from abroad minus factor income of non residents in domestic
territories.
 GDP and GNP are related as follows:
GNP=GDP + NFI
7
 Cont’d …
 NFI = Factor income earned from abroad by residents mines factor
income of non-residents in domestic territory.
 NFI could be negative, positive or zero depending on the amount of
factor income received by the two parties.
 If NFI >0, then GNP > GDP
 If NFI<0, then GNP < GDP
 If NFI =0, then GNP =GDP
 Basically, there are three approaches to measure GDP/GNP. These
are:
i. Product or value added approach
ii. Income approach
iii. Expenditure approach
8
 Cont’d …
i. Product Approach: In this approach, GDP is calculated by adding the
market value of all final goods and services currently produced by each
sector of the economy.
In this case, GDP includes only the values of final goods and services in
order to avoid double counting.
Double counting will arise when the output of some firms are used as
intermediate inputs of other firms.
There are two possible ways of avoiding double counting:

A. Taking only the value of final goods and services

B. Taking the sum of the valued added by all firms at each stage of
production.
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10
Cont’d …

11
 Cont’d …
Expenditure Approach: GDP is measured by adding all expenditures
on final goods and services produced in the country by all sectors of the
economy.

Thus, GDP can be estimated by summing up personal consumption of

households (C), gross private domestic investment (I), government purchases
of goods and services (G) and net exports (NE).
 Personal consumption expenditure includes expenditures by households
on durable consumer goods (automobiles and others goods), non-durable
consumer goods (clothes, shoes, pens, etc) and services.
 Gross private domestic investment is defined as the sum of all spending of
firms on plants, equipment, and inventories, and the spending of households
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on new houses.
 Cont’d …
 Investment is broken down into three categories:

A. residential investment (the spending of households on the construction of new

houses),
B. business fixed investment (the spending of firms on buildings and equipment for
business use),
C. and inventory investment (the change in inventories of firms).

 Note that gross private domestic investment differs from net private
domestic investment.
 gross private domestic investment includes both replacement and
added investment whereas the net private domestic investment refers
only to added investment.
13
 Cont’d …
 Replacement means the production of all investment goods, which replace
machinery, equipment and buildings used up in the production process.
 In short, net private domestic investment = gross private domestic
investment minus depreciation.
 Government purchases of goods and services include all government
spending on finished products and direct purchases of resources less
government transfer payments.
 Net exports refer to total value of exports less total value of imports. net
export is different from the terms of trade.
 terms of trade refers to the ratio of the value of exports to the value of
imports.
14
15
 Cont’d …
Income approach: in this approach, GDP is calculated by adding
all the incomes accruing to all factors of production used in
producing the national output.
 In this approach ,GDP is the sum incomes to owners of factors
of production plus some other claims on the value of output
(depreciation and indirect business tax) less subsidies and
transfer payments.
 Transfer payments may take the form of old age pension,
unemployment benefit, subsidies, etc.
16
 Cont’d …

GDP = Compensation of employees (wages & salaries )

+ Rental income
+ Interest income
+ Profits (proprietors‘ profit plus corporate profit)
+ Indirect business taxes
+ Depreciation
- Subsidies
- Transfer payments

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18
 Items Value
 Public transfers ……………………………………………... 300
 Compensation to employees…………………………..…… 1771
 Personal consumption expenditure……………………...…. 1858
 Rental income of persons...………………………………… 34
 Government purchases of goods & service……………..…. 590
 Indirect business tax ………….…………………..……....... 257
 Factor income received from abroad………………………..150
 Capital consumption allowance/depreciation………………. 322
 Value of exports…………………………………………….. 60
 Proprietor’s income…………………………………………. 134
 Corporate tax………………………………………………... 189
 Gross private domestic investment…………………………. 450
 Net interest…………………………………………………. 215
 Value of imports……………………………………………. 36
 Factor income paid for foreigners…………………………... 100
 Private transfers …………………………………………….. 150
 Cont’d …
Limitation of GDP measurement:
 The calculation of national income is not an easy task.
 We face a number of problems in the estimation of national income, especially
in under-developed countries like Ethiopia.

 Inadequate data:
 Non-monetized sector:
 No focus on quality:
 Production for self-consumption:
 The problem of double counting:
 Underground economy and so on….
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 Cont’d …

6.2.2. Other income accounts

 Apart from GDP and GNP, there are also other social
accounts which have equal importance in macroeconomic
analysis. These are:
 Net Domestic Product
 Net National Product (NNP)
 National Income (NI)

 Personal Income (PI)

 Personal Disposable Income (PDI) 21
 Cont’d …
Net Domestic Product at Market Prices (NDP)
Net Domestic Product at market prices is the net market value of all the
final goods and services produced in the domestic territory of a country
during a year.
Net Domestic Product at market prices is equal to the Gross Domestic
Product at market prices minus depreciation or capital consumption
allowance.
 NDP= GDP- Depreciation

Net National product (NNP) : Net National Product at market

prices is the net market value of all the final goods and services produced
by the normal residents of a country during a year
NNP= GNP– Depreciation OR
NNP= NDP+ NFI
22
 Cont’d …

National income (NI): National income is the income

earned by economic resource (input) suppliers for their
contributions of land, labor, capital and entrepreneurial ability,
which are involved in the given year‘s production activity.
 However, from the components of NNP, indirect business tax,
which is collected by the government, does not reflect the
productive contributions of economic resources because
government contributes nothing directly to the production in

return to the indirect business tax.

23
 Cont’d …
Hence, National Income = Net National Product – Indirect
Business Tax .

Personal Income (PI): refers to income earned by

persons or households.
 Persons in the economy may not earn all the income earned
as national income.
PI = NI – [social security contribution + corporate income tax
+ retained corporate profit] + [Public transfer payments (e.g.
Subsidy) + net interest on government bond].
24
 Cont’d …
Personal Disposable Income: it is personal income less
personal tax payments.
DI = PI – Personal taxes
DI = C + S where, C = personal consumption expenditure, S = Personal
savings.

6.3. Nominal versus Real GDP

Nominal GDP is the value of all final goods and services produced in a
given year when valued at the prices of that year.
When final goods and services included in GDP are valued
at current market prices,
 That is, nominal GDP= the sum of Pi*Qi ,
where, P is the general price level
and Q is the quantity of final goods and services produced
25
 Cont’d …
For example, Nominal GDP of 2021 is the value of output produced in
2021 calculated at the market prices prevailing in 2021.
Real GDP is the value of final goods and services produced in a given
year when valued at the prices of a reference base year.
On the other hand, when goods and services included in GDP are valued
at constant (fixed) prices i.e., prices of the base year it is called GDP at
constant prices or Real GDP.
By comparing the value of production in the two years at the
same prices, we reveal the change in output.
Hence, to be able to make reasonable comparisons of GDP overtime we
must adjust for inflation.
26
Cont’d …

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28
 Cont’d …

6.4. The GDP Deflator and the Consumer Price

Index(CPI) .
 The GDP Deflator: The calculation of real GDP gives us a useful
measure of inflation known as the GDP deflator.
 The GDP deflator is the ratio of nominal GDP in a given year to
real GDP of that year.
 It reflects what‘s happening to the overall level of prices in the
economy.

29
 Cont’d …
 The Consumer Price Index (CPI) is an indicator that measures the
average change in prices paid by consumers for a representative basket
of goods and services.
 It compares the current and base year cost of a basket of goods of fixed
composition.
 CPI measures the cost of a “market basket” of consumer goods and
services relative to the cost of that bundle during a particular base year.
The base year is a reference year.

30
Cont’d …

31
• Thus, the is the cost of basket of goods and services relative to the cost 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

• In this CPI, 2021 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 2021.
 Cont’d …
The CPI versus the GDP Deflator
 The GDP deflator and the CPI give somewhat different information
about what‘s happening to the overall level of prices in the economy.
 There are three key differences between the two measures.

1. 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.

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 Cont’d …
2).GDP deflator includes only those goods produced domestically.
 Imported goods are not part of GDP and do not show up in the
GDP deflator.

3).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.

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 6.5. The Business Cycle

Business cycle refers to the recurrent ups and downs in the level of
economic activity.
It is a fluctuation in overall economic activity, which is characterized by
the simultaneous expansion or contraction of output in most sectors.
 With the fluctuation in the overall economic activity, the level of
unemployment also moves up and down.

The business cycle have four phases:

Boom/peak: it is a phase in which the economy is producing the highest
level of output in the business cycle. It is the point which marks the end of
economic expansion and the beginning of recession.
35
Cont’d …

36
 Cont’d …
Recession/contraction: during a recession phase, the level of economic
performance generally declines.
Total output declines, national income falls, and business generally decline. As a
result, unemployment problem rises.
Trough/Depression: - this phase is the lowest point in a business cycle. It
marks the end of a recession and the beginning of economic
recovery/expansion.
Recovery/Expansion: - during this phase, the economy starts to grow or
recover, i.e. there is an option of economic activity between a trough and a peak.
In this phase, more and more resources are employed in the production process;
output increases, unemployment level diminishes and national income rises.

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 6.6. Macroeconomic Problems

6.6.1. Unemployment
 Unemployment refers to group of people who are in a specified age
(labor force), who are without a job but are actively searching for a job.
 In the Ethiopia context, the specified age is between 14 and 60 which
are normally named as productive population.
 To better understand what unemployment is, it is important to begin
with classifying the whole population of a country into two major
groups:

 those in the labor force and those outside the labor force.

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 Cont’d …
Labor force includes group of people within a specified age (for
instance, people whose ages are greater than 14 are considered as job
seekers
though formal employment requires a minimum of 18 years of age
bracket) who are actually employed and those who are without a job
but are actively searching for a job, according to the Ethiopian labor
law.
Therefore, the labor force does not include: Children <14 and retired
people age >60, and also people in mental and correctional institutions,
and very sick and disabled people etc.

39
 Cont’d …
A person in the labor force is said to be unemployed if he/she is without
a job but is actively searching for a job.
Labor force = Employed + Unemployed

Types of unemployment
1. Frictional unemployment: refers to a brief period of unemployment
experienced due to.
 Seasonality of work E.g. Construction workers
 Voluntary switching of jobs in search of better jobs
 Entrance to the labor force E.g. A student immediately after graduation
 Re-entering to the labor force
40
 Cont’d …

Structural unemployment: results from mismatch between the

skills or locations of job seekers and the requirements or locations of
the vacancies.
 E.g. An agricultural graduate looking for a job at ―Piassa. The causes
could be change in demand pattern or technological change.

Cyclical unemployment: results due to absence of vacancies.

This usually happens due to deficiency in demand for commodities/ the
low performance of the economy to create jobs. E.g. During recession
 Note: Frictional and structural unemployment are more or less
unavoidable; hence, they are known as natural level of unemployment.
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 Cont’d …
Measurement of rates of unemployment

42
 Cont’d …
 When the unemployment rate is equal to the natural rate of
unemployment, we say the economy is at full employment.
 However, full employment does not mean zero unemployment.

6.6.2. Inflation
 It is the sustainable increase in the general or average price levels
commodities.
 Price index serves to measure inflation.

43
 Cont’d …
Causes of inflation
 The causes of inflation are generally classified into two major groups:
demand pull and cost push inflation.
A. Demand pull inflation: according to demand pull theory of inflation,
inflation results from a rapid increase in demand for goods and services
than supply of goods and services.
 This is a situation where ―too much money chases too few goods.

B. Cost push or supply side inflation: it arises due to continuous

decline in aggregate supply. This may be due to bad weather, increase in

wage, or the prices of other inputs.

44
Cont’d …

45
 Tayps of inflation
 Broadly, inflation can be grouped into four types, according to its
magnitude.
 Creeping Inflation: This occurs when the rise in price is very slow.
A sustained annual rise in prices of less than 3% per annum falls
under this category.
 Walking Inflation: This occurs when the rate of rise in prices is in
the intermediate range of 3 to less than 10 per cent.
 Running Inflation: When prices rise rapidly at the rate of 10 to 20
per cent per annum, it is called running inflation.
 Hyperinflation: is often defined as inflation that exceeds 50 percent
per month, which is just over 1 percent per day. 46
 Cont’d …
6.6.3. Trade deficit and budget deficit
Trade deficit
 The national income accounts identity shows that net capital outflow
always equals the trade balance.
 Mathematically, S - I = NX.
Net Capital Outflow = Trade Balance
 If S - I and NX is positive, we have a trade surplus
 If S - I and NX is negative, we have a trade deficit

 If S - I and NX are exactly zero, we are said to have balanced trade

because the value of imports equals the value of exports.

47
 Cont’d …

Budget deficit
 The government receives revenue from taxes and uses it to pay for
government purchases.
 Any excess of tax revenue over government spending is called public
saving, which can be either positive (a budget surplus) or negative (a
budget deficit).
 When a government spends more than it collects in taxes, it faces a
budget deficit, which it finances by borrowing from internal and
external borrowing.
 The accumulation of past borrowing is the government debt.
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 6.7. Macroeconomic policy instruments

 The ultimate policy objective of any country in general is to have

sustainable economic growth and development.
 Policy measures are geared at achieving moderate inflation rate,
keeping unemployment rate low, balancing foreign trade,
stabilizing exchange and interest rates, etc.
 and in general attaining stable and well-functioning
macroeconomic environment.
 There are two major polices: monetary and fiscal policy

49
 Cont’d …
6.7.1. Monetary policy

 Monetary policy refers to the regulation of the money supply and the
control of the cost and availability of credit by the central bank of the
country.
It can be set by central bank.
Major instruments of monetary policy:
Bank Rate(discount rate):is the rate of interest at which the central
bank lends to the commercial banks.
Open Market Operation: refer to the buying and selling of
government securities which influence money supply in the economy.
50
 Cont’d …
 Cash-Reserve Ratio: Every commercial bank is required to keep with the
central bank a particular percentage of its deposits or reserves in the form
of cash.
 This percentage is called the cash reserve ratio (CRR).

 Monetary policy divided into two:

 expansionary monetary policy :it appley at the time of depression.

 Reduce Bank Rate(discount rate)
 Purchase Open Market Operation such as security
 Reduce Cash-Reserve Ratio:

 for contractionary monetary policy, the opposite of the above.

It is apply at the time of inflation 51
 Cont’d …

6.7.2. Fiscal policy

 Fiscal policy involves the use of government spending, taxation and
borrowing to influence both the pattern of economic activity and
also the level and growth of aggregate demand, output and
employment.
 It is important to realize that changes in fiscal policy affect both
aggregate demand (AD) and aggregate supply (AS).

 The most important tools of implementing the government

fiscal policy are taxes, expenditure and public debt.

52
 Cont’d …
 A fiscal policy can be of two types:
 – expansionary or contractionary – depending upon prevailing
economic conditions.
 At the time of expansionary policy the government reduce taxes,
increase expenditure
 Major functions of fiscal policy:
 Allocation Resource:

 Fair distribution income:

 Stabilization of the economy and Development: etc

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 Thanks

11/14/2022 54
 Quiz
1) ------------------refers to group of people who are in a specified age,
who are without a job but are actively searching for a job(1 pt.)

2) ----------------------refers to the regulation of the money supply,

control of the cost and availability of credit by the central bank of
the country.(1 pt).
3) ----------------------is the sustainable increase in the general or
average price levels commodities.(1 pt)
4) list and discuss two major causes of inflation (1 pt)
5) list and discuss two types of natural level of unemployment (1pt)

55
 Quiz
1) -----------------------------refers to the recurrent ups and downs
in the level of economic activity(1 pt.)
2) ------------------------------refers to group of people who are in a
specified age, who are without a job but are actively searching
for a job(1 pt.)

3) --------------------------- is the value of final goods and services

produced in a given year when valued at the prices of a
reference base year. (1 pt.)

4) List at list two key differences between CPI &GDP deflator (2

pts)
11/14/2022 56
 Quizz
1).----------------------refers to the regulation of the money supply and
the control of the cost and availability of credit by the central bank of
the country.(1 pt).

2). ----------------------is the sustainable increase in the general or

average price levels commodities.(1 pt.).
3). list and discuss two major causes of inflation (1.5 pts.).
4).list and discuss three types of unemployment (1.5 pts.)

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