HARAMAYA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS
DISTANCE EDUCATION PROGRAM

MACROECONOMICS MODULE

PREPARED BY
FREZER TILAHUN
SINTAYEHU GULILAT

CONTENT EDITOR
ARARSA ABERA

LANGUGE EDITOR
BIRHANU GEBRIEL

PEDAGOGY
BAHIR ADEM (PhD)

FEBRUARY 2023
HARAMAYA UNIVERSITY
Haramaya University Distance Education Program
 Macroeconomics Module

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transmitted in any form by any means, electronic, mechanical, photocopying, recording, or
otherwise without the prior written permission of Haramaya university.

***Published by Haramaya University, Directorate of Continuing and Distance Education***

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Table of Contents
PREFACE ....................................................................................................................................... iv
UNIT ONE: THE STATE OF MACROECONOMICS INTRODUCTION ................................... 1
1.1. Unit introduction .................................................................................................................. 1
1.2. What macroeconomics is about? .......................................................................................... 1
1.3. Basic Concepts and Methods of Macroeconomics Analysis................................................ 4
1.4. Measuring the value of economic activity ........................................................................... 4
1.5. Macroeconomic Goals and Instruments ............................................................................... 8
1.6. The State of Macroeconomics: Evolution and Recent Developments ................................. 9
Unit Summary ................................................................................................................................ 14
UNIT TWO: NATIONAL INCOME ACCOUNTS ...................................................................... 15
2.1. Unit Introduction ................................................................................................................ 15
2.2. NATIONAL INCOME ACCOUNTS ................................................................................ 15
2.3. The concepts of GDP and GNP .......................................................................................... 16
2.4. Approaches of measuring national income ........................................................................ 18
2.5. Some Other Social Accounts .............................................................................................. 23
2.6. The GDP Deflator and the Consumer Price Index ............................................................. 29
2.7. The CPI versus the GDP Deflator ...................................................................................... 31
2.8. Nominal versus Real GDP ................................................................................................. 31
2.9. The Business Cycle ............................................................................................................ 33
2.10. Unemployment and Inflation.............................................................................................. 35
2.10.1. Measuring Unemployment Rate .................................................................................. 35
2.10.2. Inflation –Unemployment Dynamics ........................................................................... 37
Unit summary ................................................................................................................................. 40
UNIT THREE: AGGREGATE DEMAND ANALYSIS ............................................................... 41
3.1. Unit introduction ................................................................................................................ 41
3.2. The Goods Market and the IS Curve .................................................................................. 42
3.2.1. Construction of the IS curve ............................................................................................ 42
3.2.2. What determines the slope of the IS curve? .................................................................... 44
3.2.3. What factors shift the IS schedule? ................................................................................. 44
3.2.4. Mathematical Representation of the IS Curve ................................................................. 48
3.2.5. Factors that shift the IS curve .......................................................................................... 49
3.3. The Keynesian Cross .......................................................................................................... 50

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 Macroeconomics Module

3.3.1. Fiscal Policy and the Multiplier: Government Purchases ................................................ 54

3.3.2. Fiscal Policy Multiplier: Taxes ........................................................................................ 57
3.4. The Interest rate, Investment and the IS Curve .................................................................. 58
3.5. The Money Market and the LM Curve .............................................................................. 60
3.5.1. The Theory of Money Demand ....................................................................................... 62
3.5.2. Money Supply .................................................................................................................. 68
3.6. The LM Curve .................................................................................................................... 69
3.6.1. The Construction of the LM Curve ................................................................................. 69
3.6.2. Factors Determining the Slope of the LM Schedule ....................................................... 71
3.6.3. Factors that Shift the LM Schedule ................................................................................. 73
3.7. The Theory of Liquidity Preference ................................................................................... 76
3.7.1. Income, Money Demand, and the LM Curve .................................................................. 79
3.7.2. How Monetary Policy Shifts the LM Curve .................................................................... 80
3.7.3. The Short-Run Equilibrium ............................................................................................. 81
3.7.4. Monetary and Fiscal Policy Analysis .............................................................................. 82
[Link]. Change in Fiscal Policy................................................................................................ 82
[Link]. Changes in Monetary Policy ........................................................................................ 83
[Link]. Interaction between Monetary and Fiscal Policy ......................................................... 84
3.8. Aggregate Demand and the ISLM...................................................................................... 85
Unit Summary ................................................................................................................................ 95
UNIT FOUR: AGGREGATE SUPPLY ANALYSIS .................................................................... 96
4.1. Unit Introduction ................................................................................................................ 96
4.2. Aggregate Supply ............................................................................................................... 96
4.2.1. The long run: The vertical aggregate supply curve ......................................................... 97
4.2.2. The short run: the Horizontal aggregate supply curve..................................................... 98
4.3. Models of Aggregate supply .............................................................................................. 99
4.3.1. The Sticky-Wage Model ................................................................................................ 100
4.3.2. The imperfect-Information Model ................................................................................. 103
4.3.3. Sticky Price Model ........................................................................................................ 104
4.4. Aggregate demand and aggregate supply in long and short run ...................................... 107
Unit Summary .......................................................................................................................... 109
UNIT FIVE: FOREIGN EXCHANGE - OPEN ECONOMY ..................................................... 110
5.1. Unit Introduction .............................................................................................................. 110
5.2. Introduction to Open Economy ........................................................................................ 111

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5.3. Foreign Exchange Market ................................................................................................ 113

5.3.1. Foreign Exchange Rates ................................................................................................ 114
5.3.2. Types of foreign Exchange Transaction ........................................................................ 114
5.3.3. Foreign Exchange Regimes ........................................................................................... 115
5.4. Fiscal and Monetary policy in open economy.................................................................. 117
5.5. The Mundell-Fleming Model ........................................................................................... 118
Unit Summery .............................................................................................................................. 123
UNIT SIX: THEORIES OF CONSUMPTION............................................................................ 124
6.1. Unit introduction .............................................................................................................. 124
6.2. Introduction to Consumption and Saving ......................................................................... 124
6.3. The Basic Model of Consumer Behaviour ....................................................................... 126
6.3.1. An Inter-temporal Model of Consumption .................................................................... 127
6.3.2. Franco Modigliani and the Life- Cycle Hypothesis ...................................................... 129
6.3.3. The Friedman Approach: Permanent Income ................................................................ 131
Unit Summery .............................................................................................................................. 135
UNIT SEVEN: THEORIES OF INVESTMENT ........................................................................ 136
7.1. Unit introduction .............................................................................................................. 136
7.2. The Meaning and Rationales for Investment ................................................................... 136
7.3. Purpose/Motive of Investment ......................................................................................... 138
7.4. Theories of Investment ..................................................................................................... 146
7.4.1. Keynesian Marginal Efficiency of Capital .................................................................... 146
7.4.2. Present Value criterion Vs Marginal Efficiency of Capital ........................................... 148
7.5. Investment Demand and Interest Rate.............................................................................. 152
7.6. Investment and saving, and their relationship .................................................................. 156
7.7. Other Theories of Investment ........................................................................................... 158
7.7.1. Accelerator Theory of Investment ................................................................................. 159
7.7.2. The Internal Fund Theory of Investment ....................................................................... 161
7.7.3. Tobin’s - Q theory of Investment .................................................................................. 162
7.7.4. Neo-classical Theory of Investment .............................................................................. 163
7.7.5. Inventory investment ..................................................................................................... 165
7.8. Some Determinants of Investment in Less Developed Countries .................................... 166
Unit Summary .............................................................................................................................. 170
Suggested Reference .................................................................................................................... 171

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PREFACE

Course Description: The course tries to introduce students with the analysis of economic activity
at macro level. By introducing National Income Accounts and the workings of modern Financial
Institutions and Monetary System the course proceeds on a detailed treatment of aggregate
economic variables such as Saving, Investment, Money, Inflation, Income determination,
Unemployment and others using various economic models as tools of analysis. It also familiarizes
students with relevant macroeconomic policy issues.
Course Objectives: After completing the course, students will be able to:
• Describe the concept of National Income Accounting.
• Explain the controversies in macroeconomics.
• Explain basic IS-LM model
• Use macroeconomic policy instruments

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Introduction to the module

Dear learner! This is your distance material for the course Macroeconomics and it consists
of seven units. Unit one, the introductory unit, consists of microeconomics Vs macroeconomics,
and school of thought in macroeconomics. Unit two, measurements of macro-economic variables.
In the third unit we are going to see goods market and IS-curve, money market and LM-curve,
equilibrium in goods and money market, derivation of aggregate demand curve and fiscal and
monetary policy in the IS-LM model. The fourth unit deals with aggregate supply analysis. In unit
five we will see introduction to open economy macroeconomics and exchange rate markets, unit
six is about consumption theory and finally unit seven deals with the theory of investment and
saving.

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 Macroeconomics Module

Module objectives
The following are the objectives that you should aspire to achieve in studying this module. After
completing this module, you will be able to know:

➢ The difference between macro and microeconomics

➢ The evolution of macro economics
➢ Basic concepts and methods of macroeconomic analysis
➢ Aggregate demand analysis
➢ Aggregate supply analysis
➢ Exchange rate markets: Open economy macroeconomics
➢ Theory of consumption
➢ Saving and investment
To check your understandings please try to practice self-test questions that are given at the end of
each unit. We hope at the end of reading this material you will grasp better knowledge about
macroeconomics.
We hope that you will enjoy studying this module and work hard to make the best out of your study.
Finally, we would like to advise you to spend sufficient time to study the module.
For the sake of simplicity with in each unit there are a number of sections which are further divided
in to subsections. In each Section a clear statement of objectives and principles are illustrated with
examples which are followed by a number of check lists and self-test questions.

I hope you will enjoy the course, develop the knowledge and skill of how to conduct problem
solving economics related research. Constructive suggestions from you, for further improvements
of the materials, are most welcome.

Have a nice Reading!

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UNIT ONE: THE STATE OF MACROECONOMICS INTRODUCTION

1.1. Unit introduction
The purpose of this unit is to introduce students about the fundamental concepts and meanings of
macroeconomics. This unit is devoted to discuss about the introductory issues on major
macroeconomic objectives, variables and methods of measurement. Macroeconomic problems such
as inflation, and unemployment are also presented with their respective methods of measurement.
More specifically, the unit also discusses the branches of economics, major element of
macroeconomic analysis and the historical evolution of the discipline.
We believe that this unit helps you to know what macroeconomics and the major macroeconomic
variables.

At the end of this unit students are expected to:

➢ Define economics;
➢ Distinguish between macroeconomics and microeconomics;
➢ Measurement of macroeconomic variables
➢ Explain objectives of macroeconomics;
➢ Explain macroeconomic problems; and
➢ Explain the evolution of the discipline at deferent schools of thought.

1.2. What macroeconomics is about?

Dear learner! Why have some countries experienced rapid growth in incomes over the past century
while others stay stuck in poverty? Why do some countries have high rates of inflation while others
maintain stable price? Why all countries do experiences recession and depression-recurrent periods
of falling incomes and rising unemployment- and how can government policy reduce the frequency
and severity of these affair? These and other questions can be answered if we have the knowledge
of macroeconomics.

Micro versus Macroeconomics

Dear learner! Can you give us the definition of Economics? ----------------------------------

------------------------------------------------------------------------------------------- Good!

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 Macroeconomics Module

Economics has no single definition; different scholars give different definition of economics; let us
see some of them;
Adam Smith defines Economics as “an inquiry into the nature and cause of the wealth of nation.”
Alfred Marshall defines “Economics is the study of mankind in the ordinary business of life; it
examines the part of individual and social action which is most closely connected with the
attainment and with the use of the material requisites of well-being.”

Paul A. Samuelson “Economics is the study of how men and society choose, with or without the
use of money, to employ the scarce productive resources which could have alternative uses, to
produce various commodities over time and distribute them for consumption now and in the future
amongst various people and groups of society.”

Dear learner these are some of the definitions of economics; but there are also a lot which is
difficult to mention in this single material. But all of them have similar message about economics
i.e., economics is a subject which deals with how human beings use the scarce resources in order
to fulfill their unlimited wants.

Economics is divided into two major branches: Microeconomics and Macroeconomics. The terms
‘micro-economics’ and ‘macro-economics’ are used to denote the two branches of economics.
These terms also connote the two different kinds of economics issues and economics studies,
depending on whether a part or the whole of economic system is covered under economic analysis.

Dear learner! Can you guess the difference between macroeconomics and
microeconomics? ---------------------------------------------------------------------------------------------
---------------------------------------------------------- Excellent!
When an economic deals with economic behavior of an individual decision-making unit (consumer
and producer) or an economic variable (Price and quantity of a good) it is Microeconomics.
Whereas, when an economic analysis deals with aggregates like national income, employment,
aggregate consumption, savings and investment, general price level, and balance of payments
position, etc., it is called Macroeconomics.
➢ Macroeconomics is a policy-oriented part of economics. The subject matter of macroeconomics
includes factors that determines both the level of macroeconomic variables such as: total output,

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 Macroeconomics Module

aggregate price level, employment and unemployment, interest rates, wage rates and foreign
exchange rates and how the variables are change over time.

➢ 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 rate
of inflation and unemployment, the balance of payments, and exchange rates.

➢ Macroeconomics focuses on the economic behavior and policies that affect consumption and
investment, trade balance, the determinants of changes in wages and prices, monetary and fiscal
policies, the money stock, government budget, interest rate, and national debt.

➢ In macroeconomics, we do two things. First, we seek to understand the economic functioning

of the world we live in; and, second, we ask if we can do anything to improve the performance
of the economy. That is, we are concerned with both explanation and policy prescriptions.
Differences between micro and macro economics

Microeconomics Macroeconomics
➢ The study of smaller scope of economic ➢ The study of a bigger scope of
activity. economic activity
➢ It examines the functioning of individual ➢ It focuses on the determinants of total
industries and the behavior of individual national output aggregate decision
decision-making units. making.
➢ It deals with the whole national
➢ It deals with household income only.
income.
➢ It analyses the individual prices of goods ➢ It analyses the overall general price
and services. level.

Self-test
1. What is economics?
2. What does macroeconomics deals with?
3. Briefly explain the difference between macro and microeconomics?

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 Macroeconomics Module

1.3. Basic Concepts and Methods of Macroeconomics Analysis

In this sub topic we are going to discuss the methods that help us to measure one of macro-economic
variables.

Dear learner! Can you list the macroeconomic variables? --------------------------------------

----------------------------------------------------------------------------- Good!

The major macroeconomic variables are: Output, Unemployment, and Inflation.

➢ Output: Is the production of goods and services or the national income of the country.
➢ Unemployment: unemployment rate is the percentage of the labour force that is not
employed.
➢ Inflation: Is the general increase in the price level.

1.4. Measuring the value of economic activity

The national income measures the economic activity of a country.

What is national income?

It includes:
➢ The national income of a country in a year is the value, expressed in monetary terms of the net
contribution of the factors of production through the production units in the country and abroad
in the year.

➢ It is thus, the monetary expression of the current flow of net final good and services resulting
from the production activities of the normal residents of a country during the year.

➢ Concretely, national income is the net domestic product (or net domestic income) of a country
plus net income from abroad.

➢ If all the national income is in fact consumed then the national income consists of consumer’s
goods and services only. If only a part of the national income is consumed in the year then the
part that remains accumulate as a stock of goods or as capital stocks. National income then
would consist of consumer’s goods and services plus increase in stocks of goods, i.e., of

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consumption plus investment. Net investment includes increase in the stocks of fixed capital
goods and working of capital goods.

➢ If however, people consume more than the national income then it would probably mean that
the stock of capital goods has been eaten into or that the people have received gifts from abroad.
Gifts from abroad refer to current transfer from abroad of consumer goods and services.

➢ The national income is, thus the goods and services available to the normal residents in a
country, as a result of their production efforts in the year, to consume or to invest.

Dear learner! Having the idea of national income (output) in the above paragraph what do
you think the significance of national income? -----------------------------------------------------------
--------------------------------------------------------------------------------------------Excellent!
The significance of national income is that it is the value of the goods and services, which can be
used up in consumption by the residents of the country. It represents that part of the flow of goods
and services generated by the production process, which is produced in order to satisfy the wants
of the people.

In simple words, national income is the aggregate factor income (i.e., earning of labour and capital,
etc), which arises from the current production of goods and services by the nation’s economy. The
nation’s economy refers to the factor of production (labour and capital) supplied by the normal
residents of the national territory.
From the above definitions it is clear that the concept of national income has three types of
interpretations:
➢ National income represents a total receipt,
➢ National income represents a total expenditure, and
➢ National income represents a total value of production.

This three-fold interpretation takes place because of the fact that every expenditure is at the same
time a receipt, and if goods or services bought are valued at their sales prices, we have a three-fold
identity that the value received equals the value paid, equal the value of goods and services given
in exchange.

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 Macroeconomics Module

A description of the above definition brings out three points. Firstly, national income refers to the
income of a country, say, Ethiopia. Secondly, its measurement refers to a specified period of time,
say, a year. Thirdly, national income includes all types of goods and services, which have an
exchange value, counting each one of them only once.

When we calculate the national income of a nation, we should remember that no commodity or
service should be counted twice; otherwise, the results will not be accurate. For example, if raw
cotton has been evaluated in agricultural production, it should not be included while calculating the
total value of cotton textiles. In the same manner, the value of raw cotton have to be kept out while
calculating the total value of readymade garments, such as, bush-shirts and trousers made out of
cotton textiles.

Generally, two statistical methods are used to avoid double counting or multiple counting in the
calculation of national income:
1. Final products method, and
2. Value-added method

According to the first method:

✓ We add up the value of final products only. We first take the total value of the final consumer
goods produced in the country during the year.
✓ To this, we add the total value of durable producer goods, such as, machinery and plants, etc.
✓ This will provide us the aggregate value of all the final goods produced in the country during
the year.
✓ Collective and government services (evaluated at cost price) are also to be added to this
aggregate value of the final goods in order to arrive at the total product of the nation concerned.

According to the second method:

➢ We do not take in to account the value of the final goods and services produced in the
country.
➢ On the contrary, we go on adding the values created at each stage in the manufacturing of a
commodity.
➢ Then, all such values accruing at all processes in the manufacturing of all commodities are
added up together to arrive at the national income of the country.

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 Macroeconomics Module

Dear learner! To make you clear about the value-added method let us consider the following
example.

Example: Let us suppose that a ready-made bush-shirt passes through four stages of production.
In the first stage, the farmer produces raw cotton from the soil. In the second stage, the raw cotton
is converted in to cotton cloth in a factory. In the third stage, the cotton cloth is converted in to a
bush-shirt by the ready-made garments firm. In the fourth stage, the ready-made bush-shirt is
sold to a retailer from whom the customer finally purchases it. Now money value of all the
transactions, which take place in the various stages of production of a bush-shirt, should not be
added up while making an estimate of the national income of the country; otherwise, there will
be multiple counting and the result will not be accurate.

Factors determining national income

There are a number of influences that determine the size of the national income in a country. It is
on account of these influences that one country may have a larger national income than another.
The following are the three main influences:

1. quantity and quality factors of production. The quantity and quality of a country’s stocks
of the factors of production is one of the most important influences on its national income. The
quantity and quality of land, the climate, the rainfall etc., determine the quantity and quality of
agricultural production, and hence, the size of national income. The quantity of a labour has doubled
influences since labour is at the same time both a factor of production as well as the consumer of
what is produced. The quality of labour, depending upon inborn intelligence, education and training,
also influences the volume of industrial production. Capital may comprise simple, primitive tools
or the most modern type of industrial equipment. The quantity and quality of capital is one of the
greatest influences on total output. Likewise, the quantity and quality of entrepreneurial ability is
also an important element to consider with in the determination of the size of national income of a
country.

2. The state of technical know-how: Another influence on output and national income is the
state of technical know-how in the country. A country with a poor technical knowledge cannot have

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a large-sized national income, because it will not be in a position to make the best possible use of
its resources.

3. Political stability: Political stability is an essential prerequisite for maintaining production

at the highest level.

1.5. Macroeconomic Goals and Instruments

Macroeconomics studies the working of an economy in aggregation or as a whole. And from the
conventional perspective it aimed at how;
i. To achieve full employment: it is a major concern of every economy. Full employment is a
situation where all economic factors are fully utilized and there is only frictional unemployment
exists.
ii. To obtain a satisfactory rate of economic growth: economic growth is a situation where the
economy experiences an increase in its national income over a period of time.
iii. To maintain the stability of the general price level: General Price level represents the average
price level of goods and services in the economy. It shows the rate of inflation in the economy.
iv. To ensure the Balance of Payment (BOP) equilibrium: concerns with the payment and
income received by the economy from its international trade activities. The balance of inflow
and outflow.
v. To ensure the equal distribution of income: gap between higher income group and lower
income group should be addressed.
To realize those macroeconomic objectives there are three broad policy instruments
➢ 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.
➢ Monetary policy: refers to the adoption of suitable policy regarding the control of money
supply and the management of credit which is important measure for adjusting aggregate
demand to control inflation. It is concerned with the money supply, lending rates and interest
rates and is often administered by a central bank.
➢ Income Policy: Direct attempts by government to control prices and wages

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1.6. The State of Macroeconomics: Evolution and Recent Developments

In relation to the role of government and methods of economic analysis, there are different schools
of thought emerged.
Dear learner! Let us now see different school of thought in macroeconomics that have a dominant
contribution in the development of the discipline:
➢ Classical school (1776 – 1870): during this period there was no much distinction between micro
and macroeconomics. The ruling principle was the invisible hand coined by Alfred Marshall.
➢ Neo-classical school (1870 – 1936). Basically, the neo-classical school is not different from
the classical school. The main distinction lies in is the tool of analysis. Neo-classical used the
concept of marginal analysis and the mathematics, with which to execute it whiles the classical
policy, and the concept of demand and supply.
➢ Keynesian school (1936 – 1970s). The main thesis of the Keynesian stream is that the economy
is subjected to failure so that it may not achieve full employment level. Thus, government
intervention is inevitable.
➢ 1970s – Present. There is no dominant school of thought of macroeconomics.
Macroeconomists (school of thought in macroeconomics) argue with regard to the government
intervention in the economy; parts of them believe the need for government involvement to the
economy while parts of them do not.

Dear learner! Can you tell us about your opinion in this regard? ------------------------------
-------------------------------------------------------------------------------------------------------- Great!
There have been two main intellectual traditions in macroeconomics. One school of thought
believes that government intervention can significantly improve the operation of the economy; the
other believes that markets work best if left to themselves. In the 1960s, the debate on these
questions involved Keynesians, including Franco Modigliani and James Tobin, on one side, and
monetarists, led by Milton Friedman, on the other side. In the 1970s, the debate on much the same
issues brought to the fore a new group- the new classical macroeconomists, who by and large
replaced the monetarists in keeping up the argument against using active government policies to try
to improve economic performance. On the other side are the new Keynesians; they may not share
many of the detailed belief of Keynesians three or four decades ago, except the belief that
government policy can help the economy perform better.

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Let us see different schools of thought in detail in macroeconomics.

1. Keynesian’s View of the Economy

Dear learner! In a very simplified form, we can present Keynes’s theory of recessions. Imagine an
economy that is chugging along happily at full employment. Alongside the smoothly functioning
‘real’ economy there will be a smooth financial flow, as firms earn money from their sales, pay out
their earnings in wages and dividends, and household spend these receipts on new purchases from
the firms.

But now suppose that for some reasons each household and firm in this economy decides that it
would like to hold a little more cash. Keynes argued, in particular, this happens when businessmen
lose confidence and start to think of potential investments as risky, leading them to hesitate and
accumulate cash instead; today we might add the problem of nervous households who worry about
their jobs and cut back on purchases of big-ticket consumer items. Either way, each individual firm
or household tries to increase its holdings of cash by cutting its spending so that its receipts exceed
its outlays.

But as Keynes pointed out, what works for an individual does not work for the economy as a whole,
because the amount of cash in the economy is fixed. An individual can increase her/his cash holding
by spending less, but she/he does so only by taking away cash that other people had been holding.
Obviously, not everybody can do this at the same time.

Dear learner! Can you guess what will happen when everyone tries to accumulate cash
simultaneously? -----------------------------------------------------------------------------------------------
-------------------------------------------------- Good!
The answer is that income falls along with spending. We try to accumulate cash by reducing my
purchases from you, and you try to accumulate cash by reducing your purchases from us; the result
is that both of our incomes fall along with our spending, and neither of us succeed in increasing our
cash holdings.

If we remain determined to hold more cash, we will react to this disappointment by cutting our
spending still further, with the same disappointing result; and the like. Looking at the economy as
a whole, you will see factories closing, workers laid off, stores empty, as firms and households

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throughout the economy cut back on spending in a collectively hopeless effort to accumulate more
cash. The process only reaches a limit when incomes are so wasted that the demand for cash falls
to equal the available supply.

Keynes and Economic Policy

For Keynes to do about recessions, the first and most obvious thing to do is to make it possible for
people to satisfy their demand for more cash without cutting their spending, preventing the
downward spiral of shrinking spending and shrinking income.

Dear learner! How is it possible to increase income of individual without cutting their
spending? -----------------------------------------------------------------------------------------------------
-------------------------------------------------- excellent!

The way to do this is simple to print more money, and somehow get it into circulation. So, the
usual and basic Keynesian answer to recessions is a monetary expansion. But Keynes worried that
even this might sometimes not be enough, particularly if a recession had been allowed to get out of
hand and become a true depression. Once the economy is deeply depressed, households and
especially firms may be unwilling to increase spending no matter how much cash they have; they
may simply add any monetary expansion to their hoarding. Such a situation, in which monetary
policy has become ineffective, has come to be known as a “liquidity trap”. In such a case, the
government has to do what the private sector will not spend. When monetary expansion is
ineffective, fiscal expansion must take its place. Such a fiscal expansion can break the vicious circle
of low spending and low incomes and getting the economy moving again.
2. Monetarism
Monetarism, as advocates of free market, started challenging Keynes’s theory in the 1970s. Milton
Friedman, the founder of monetarism, attacked Keynes idea of smoothing business cycle on the
ground that such active policy is not only unnecessary but actually harmful, worsening the very
economic instability that it is supposed to correct, and should be replaced by simple, mechanical
monetary rules. This is the doctrine that came to be known as “monetarism”.

Friedman began with a factual claim: most recessions, including the huge slump that initiated the
Great Depression, did not follow Keynes’s script. That is, they did not arise because the private

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sector was trying to increase its holdings of a fixed amount of money. Rather, they occurred because
of a fall in the quantity of money in circulation.

Policy Rule under Monetarism

If economic slumps begin when people suddenly decide to increase their money holdings, then the
monetary authority must monitor the economy and pump money in when it finds a slump is
imminent. If such slumps are always created by a fall in the quantity of money, then the monetary
authority need not monitor the economy; it need only make sure that the quantity of money doesn’t
slump. In other words, a straightforward rule- “Keep the money supply stable”- is good enough, so
that there is no need for a “flexible” policy of the form, “Pump money in when your economic
advisers think a recession is coming up.”

3. The New Classical School

Dear learner! The new classical macroeconomics remained influential in the 1980s. This school
of macroeconomics shares many policy views with Friedman. It sees the world as one in which
individuals act rationally in their self-interest in markets that adjust rapidly to changing conditions.
The government, it is claimed, is likely only to make things worse by intervening.

The central working assumptions of the new classical school are three:
➢ Economic agents maximize: that is households and firms make optimal decisions given all
available information in reaching decisions.
➢ Expectations are rational: this means they are statistically the best predictions of the future
that can be made using the available information. Rational expectations imply that people will
eventually come to understand whatever government policy used, and thus that it is not possible
to fool most of the people all the time or even most of the time.
➢ Markets clear. There is no reason why firms or workers would not adjust wages or prices if that
would make them better off. Accordingly, prices and wages adjust in order to equate supply and
demand; in other words, market clear. For instance, any unemployed person who really wants
a job will offer to cut this or her wage until the wage is low enough to attract an offer from some
employer. Similarly, anyone with an excess supply of goods on the shelf will cut prices so as to
sell. The essence of the new classical approach is the assumption that markets are continuously
in equilibrium.

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4. The New Keynesians

Dear learner! Do you know the idea of New-Keynesians on macroeconomic problem? --

------------------------------------------------------------------------------------------------------------------
----------------------------------- Good!

The new classical group remains highly influential in today’s macroeconomics. But a new
generation of scholars, the new Keynesians, mostly trained in the Keynesian tradition but moving
beyond it, emerged in the 1980s. They do not believe that markets clear all the time but seek to
understand and explain exactly why markets fail.

The new Keynesians argue that markets sometimes do not clear even when individuals are looking
out for their own interests. Both information problems and costs of changing prices lead to some
price rigidities, which help cause macroeconomic fluctuations in output and employment. For
example, in the labour market, firms that cut wage not only reduce the cost of labour but also are
likely to wind up with a poorer quality labour. Thus, they will be reluctant to cut wages.

Dear learner! Can you identify the difference and similarities of the above school of
thought? -------------------------------------------------------------------------------------------------------
------------------------------------------------ Good!

All school of macroeconomics agree on the purpose of macro policy but they disagree on how to
achieve the macro-objectives of higher output, lower level of unemployment and inflation rate.

Self-test
1. Briefly explain the idea of each school of thought for macro-economic problem?
2. What are the similarities of schools of thought in macroeconomics?
3. What difference do schools of thought in macroeconomics have?

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Unit Summary
➢ There is no single definition for Economics but the most comprehensive one is, Economics is a
subject which deals with how people use the limited (scarce) resources to satisfy their unlimited
desire(wants)

➢ The two branches of economics are Micro and Macro Economics. The first deals with
individuals or business firm’s decision making whereas the latter is about the aggregate level
of output, inflation and Unemployment.

➢ National income is the total output put of the country. National Income Accounts are the
measure of national income of the country among which GDP is the most common national
Income Account.

➢ The most commonly used measure of the level of prices is the consumer price index (CPI) and
it is a measure of cost of living.

➢ Unemployment rate is the statistic that measures the percentage of those people wanting to work
who do not have jobs.

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UNIT TWO: NATIONAL INCOME ACCOUNTS

2.1. Unit Introduction
In this unit, we will study how to record the entire economic activity of a country that shows the
economic activities of a country in some specific time interval. The economic performance of a
country will also be analyzed using business cycle in this unit. We will also introduce the
relationship between major macroeconomic variables; GDP, inflation, unemployment and so forth.

At the end of this unit, student will be able to:

➢ Define national income account;

➢ List major macroeconomic models;
➢ Calculate the national output, GDP or GNP, NDP, and so on;
➢ Distinguish between real GDP and Nominal GDP; and
➢ Explain approaches of measuring national output.

2.2. NATIONAL INCOME ACCOUNTS

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. Why
do we need to study 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.
- It enables us to observe the long run trend of the economy.
- It provides information to formulate policies and design plans.

Dear learner! Can you guess what national income accounts are? ----------------------------
--------------------------------------------------------------------------------------------------------- Good!

➢ National income accounts are the instruments that help us to measure the national income of
the country.
➢ The various types of national income accounts help us to measure the level of production in the
economy at some point of time, and explain the immediate causes of the level of performance.

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Let us study the seven measurements of national income accounts. They are:

1. Gross national product (GNP)

2. Net national product (NNP)
3. National income (NI) or net national income at factor cost (NNI at factor cost)
4. Net domestic product at factor cost (NDP at factor cost)
5. Personal income (PI)
6. Disposable personal income (DPI); and
7. Real income (RI)
Thus, instead of giving a single comprehensive estimate of national income, the economists use
different aggregates. The reasons for this are:

➢ There is disagreement among the economists over what should and what should not be counted
as national income. Instead of passing a judgement on this controversy, the statistics department
of the government gives some totals leaving it to each user to select the one he prefers.
➢ Another reason for this is that a certain total may be most useful for one purpose and a different
total for another purpose.

2.3. The concepts of GDP and GNP

Gross National product (GNP)

Have you ever heard what is Gross National Product is? Good, lets discuses about it here

➢ The gross national product is the basic social accounting measure. It is the most frequently used
national income aggregate in economic discussion.
➢ It is the nation’s total production of goods and services (Usually for one year) evaluated in terms
of the market prices of goods and services produced.
➢ It includes all the economic productions in the economy during one year.
➢ Strictly speaking, then the GNP is the money value of the total national production for any given
period.
Gross Domestic product (GDP)
Here we have also another national income accounts what we call Gross domestic product (GDP).
The single most important measure of overall economic performance is Gross Domestic Product

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(GDP). The GDP is an attempt to summarize all economic activity over a period of time in terms
of a single number; it is a measure of the economy’s total output and of total income. In other words,
GDP is the total value of all final goods and services produced in the economy in a given time
period (note that GDP is a flow not a stock).
GDP and GNP
Dear learner! Have you got the difference between GDP and GNP from their definitions?
-------------------------------------------------------------------------------------------------------------------
---------------------------------- Good!

There is a distinction between GDP and GNP.

➢ GNP is the value of final goods and services produced by domestically owned factors of
production within a given period.
➢ While GDP is the value of final goods and services produced with in the country’s territory with
in a given period, the factors of production used might not be domestically owned.
➢ The difference between GDP and GNP corresponds to the net income earned by foreigners.
When GDP exceeds GNP residents of a given country are earning less abroad than foreigners
are earning in that country. In Ethiopia, GDP has exceeded GNP since 1981 (based on the data
available in World Development Indicators CD-ROM, 2000) but the gap is well below 1%
(0.75% to be exact) during 1981 – 1998.
➢ In simple words, GDP is territorial while GNP is national.

Two points must be kept in mind while calculating the GNP or GDP of a country.

➢ Firstly, we must take in to account the money value of the final goods (and services) produced
in the economy to avoid double or multiple counting. It should be remembered that final goods
and services are those, which are finally consumed by the consumers. Such goods and services
do not enter in to the manufacture of other goods. As against this, intermediate goods and
services are those goods and services, which do enter in to the production of other goods and
services (Bread, for example, is final good, but flour is an intermediate good). Intermediate
products are to be excluding from the GNP.

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➢ Secondly, we must take in to account the money value of only currently produced goods and
services while estimating the GNP of the country. This is due to the fact that the GNP is a
measure of the economy’s productivity during a particular period of time.

2.4. Approaches of measuring national income

There are two methods of estimating the GNP of a country. Both the methods lead to the same
results. The two methods are: Expenditure approach and Income approach.

1. Expenditure Approach to GNP: The GNP can be viewed as the nation’s total expenditure on
goods and services produced during the year. Each unit of goods and services produced is
matched by an expenditure on that unit. The consumers buy most of the goods and services
produced in the country. But there are some goods and services, which remains unsold. If the
unsold goods and services were regarded as having been bought by the producers who hold them
as stocks or inventories, then the monetary value of the total national production would be equal
to the total national expenditure.

Under the expenditure approach to GNP, the total national expenditure can be broken down in
to the following categories:

A. Personal Consumption Expenditure (C). It includes the consumption expenditure made for
both durable goods (such as, motor-cars, radio-sets, etc., but not houses) and non-durable
goods (such as, food, drinks, clothing, etc.) produced in the country during the year. This
sub-head also includes expenditure on the purchase of a house is treated as investment rather
than consumption expenditure.

B. Gross Domestic Private Investment (I). This item includes private investment in ‘capital’
or ‘producer goods’, such as, buildings, machinery, plant, equipment, etc; business firms
primarily purchase such goods. Houses are also included in this category of expenditure,
because they are so durable that they represent, in fact, capital goods. Three points should
be carefully noted here.

➢ Firstly, this sub-head includes capital or investment goods needed not only to replace the
existing depreciated capital goods, but also the capital goods require increasing the
society’s production of goods and services.
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➢ Secondly, the term ‘investment’ here means real investment in the Keynesian sense rather
than financial investment. It means the purchase of real investment goods, such as,
buildings, machinery, plant, etc. Produced during the year. If a person buys 5-year-old
machinery, it is not real investment, though it may be called financial investment, because
that machinery was included in the GNP five years ago when it was manufactured first.

➢ Thirdly, ‘investment’ here does not include mere financial transfer, such as, the purchase
of existing stocks and shares on the stock exchange. The purchase of existing stocks and
shares does not represent new investment for purposes of the national income accounts.
Since it does not involve any production.

C. Governments’ Purchases of Goods and Services (G). The governments-central, state and
local-purchase from the market consumer goods, such as, paper, stationery, cloth, etc, as well
as investment goods, such as machinery, equipment, plant, etc, for their own enterprises. In
addition, the governments also purchase a number of different services-military, police,
secretarial etc. Governments do spend large amounts of money on what are called transfer
payments (e.g., unemployment insurance and social security payments). Since these payments
are not payments for currently produced goods and services, the amount spent on transfer
payments included in the GNP of the country.

D. Net Foreign Investment. As is well known, the entire production of a country is not sold
within the country. A part of it is the GNP of the country. At the same time, the country
imports some finished goods from other countries during the year. To make proper allowance
for such exports and imports, the value of imports should be deducted from the value of
exports. If the balance is positive, it should be added to the other items of expenditure. If it is
negative, it should be subtracted from the sum of the other expenditure items.

Illustration
GNP = C +I + G + FI,
Where;
GNP - Gross National Product
C- Personal consumption expenditure

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I- Gross domestic private investment

G- Government purchases of goods and services
FI - Net foreign Investment

It is; thus, clear that if the entire production of a country is purchased at market prices, the amount
so spent will represent the GNP of the country. Therefore, to estimate the GNP, we have to add the
above four categories of expenditure.

Dear learner! Having the above method of calculating GNP how can we get the value of
GDP? ---------------------------------------------------------------------------------------------------
-------------------------------------------------- Very Good!

We know the difference between GDP and GNP is the net factor income from abroad (NFIA) which
is the difference between Income received from abroad from the citizen of the country (IRFA), and
the income paid to the foreigner (IPTA):

NFIFA= IRFA - IPTA

Gross domestic product, the market value of all final goods and services produced in the country
territory irrespective of citizenship, is the difference between GNP and net factor income from
abroad.

Symbolically: GDP= GNP – NFIFA

As a result, the above approach to calculate GNP also works to Calculate GDP. Therefore, we reach
up on
GDP= C +I + G + FI +NFIFA

If there is no net factor income received from abroad:

GDP=GNP= C +I + G + FI

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2. Income Approach to GNP. The expenditure incurred on purchasing goods and services
produced in a country during the year also becomes the income of the various factors, which
collaborated in the production of those goods and services. We can group these factor-incomes
in the following categories:
A. Wages and salaries of the employees (or compensation to employees),
B. Incomes of non-company business
C. Rental incomes of persons
D. Corporate profits, and
E. Incomes from Interest
➢ The first category, as said above, includes the wages and salaries received by the employees
during the year plus certain supplements. These supplements are the contributions, which the
employers make to social security and other provident funds or pension funds of the workers.

➢ The second category includes the incomes earned by individual proprietors, parents and self-
employed persons.

➢ The third category comprises rental income earned by individuals on agricultural and non-
agricultural property.

➢ The fourth category includes corporate profits earned by business corporations before the
payment of corporate profit taxes or the payment of dividends to the shareholders. Thus, the
corporate profits, used in calculating the GNP, are equal to the sum of corporate profit taxes
plus dividends paid to the shareholders plus undistributed corporate profits.

➢ The fifth category contains net interest earned by individuals from sources other than the organs
of the government.

An aggregate of the above five categories of incomes will not be equal to the GNP as estimated by
the expenditure method. The reason is that a part of the total expenditure incurred by the community
does not become available to the other factors of production in the form of incomes. There are two
such leakages.

➢ First, indirect taxes levied by the government on goods and services; and
➢ Second, depreciation of machinery, plants and buildings.

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The expenditure incurred by the households (factors) on goods and services includes the indirect
taxes levied by the government. The income from these indirect taxes goes to the government and
is not available to the households (factors). Likewise, while calculating the GNP, we include the
depreciation (loss in value suffered by machinery, equipment, buildings etc.). Like the indirect
taxes, the payment on account of depreciation does not become available to the households (factors)
in the form of income. In other words, depreciation is no part of the factor incomes. Therefore,
while estimating the GNP by the Income Method, we have to add indirect taxes and depreciation
charges to the factor incomes.
GNP in the Income Method can be calculated as follows:

Illustration

GNP = W/S +I + R + Π + r + IT + D
Where;
GNP - Gross National Product
W/S - Wages and salaries of employees
I- Income of non-company business
R- Rental incomes of persons
Π- Corporate profits
r- Income from net interest
IT - Indirect taxes
D- Depreciation of capital goods

Therefore, GDP= W/S +I + R + Π + r +IT+ D –NFIFA

Or
GDP= GNP –NFIFA

Dear learner! GDP and GNP are the most frequently used national income concepts. They have
their own merits and demerits.
Merits
➢ They are better index, than any other concept, of the actual conditions of production and
employment in a country during a specified period.

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➢ They are also statistically simpler concepts, as it takes no account of depreciation and
replacement problems.
Demerits
➢ They are not a net measure of the nation’s economic performance, for they are, as the term
states, a gross measure.
➢ They don’t include the cost for environmental protection
➢ Since they are the measure of the market value of all final goods and service, they do not
incorporate the non-market activities i.e., Underground Economy.

2.5. Some Other Social Accounts

1. Net National Product (NNP) and Net Domestic Products NDP)

Dear learner! Can you guess what NNP and NDP are? ----------------------------------------
-------------------------------------------------------------------------------------------------- Good!

The second important concepts of national income are net national product and net domestic
product. Net national product is defined as the net production of goods and services produced by
citizens of a country during a year and net domestic product is defined as the net production of
goods and services produced in a country territory during a year.

As we know, in the course of a year’s production, part of the physical plant that was on hand at the
beginning of the year is worn out, or it may depreciate in value as it becomes out-dated. Building
gradually deteriorate, machinery wears out or becomes obsolete, and so on for others. No sooner or
later, if depreciated capital is not replaced, the income of the nation will decline, and the economy
as a whole will become poorer. If we want to measure the level of income that can be sustained
therefore, we must deduct from gross output (GNP or GDP) the depreciation of capital during the
period concerned. What is left after this deduction is the net national product.

Thus,
NNP= GNP – Depreciation

NDP= GDP - Depreciation

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Net products are better concepts than gross products, because it makes proper allowance for the
depreciation suffered by capital goods during the period under consideration. These concepts give
a proper idea of the net increase in total production of a country. They are, therefore, used in
analysing the long-period problems of maintaining and increasing the supply of capital goods in the
country.

In spite of this fact that for some purposes of economic growth NNP is much more important than
GNP, it is more difficult to measure statistically, because we have no accurate record of the amount
of depreciation for various capital goods, such as, buildings, equipment, plants etc. The result is
that the deduction that has to be made from GNP to arrive at NNP is a matter of judgement, rather
than of exact measurement. Because of this difficulty, this concept of NNP is not fairly used.

2. Net National Income at Factor Cost (NNI)

National Income at factor cost means the sum of all incomes earned by resource suppliers for their
contribution of land, labour, capital and entrepreneurship during the year’s net production. In other
words, national income at factor cost shows how much it costs society in terms of economic
resources to produce that net output. Sometimes, we simply call it national income.

Both GNP and NNP measure the values of goods produced in industry at the prices that those goods
actually bring in the market. Here the difficulty is that when we buy these goods at market prices,
then the prices include the respective taxes on these goods levied by the government. Hence, not
all of the payment made for goods goes to the people who produced them. Some part of it goes to
the government. It does not constitute a part of the true cost of producing the goods concerned. This
violates the basic identity that the value of goods produced is equal to the sum of the money incomes
received by the producers. In other words, the GNP will exceed the sum money incomes received
by people of the country (resource suppliers). The excess is explained by the fact that we have
included in GNP the entire output of government services, but we have also included part of the
payments made for these services in the prices of the products (in terms of sales tax). In other words,
a part of the cost of government has been counted twice. In order to get rid of this double counting,
we may introduce the concept of net national income at factor cost. It is equal to net national product
minus indirect tax plus subsidies. To put it differently:
NI= NNP-IT +S

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Where,
NI - National income (at Factor Cost)
NNP Net National Product (=National Income at Market price)
IT Indirect Taxes
S Subsidies
The concept of national income at factor cost occupies an important place in economics. It indicates
the nature of distribution of wealth among various factor inputs. This concept is more satisfactory
than the concept of GNP and NNP, because it eliminates the element of double counting inherent
in those two concepts. It accords with the basic principle of economic theory, that the payments
received by the factor suppliers equal the value of the goods produced. Further, the components of
national income (at factor cost) are very useful in dealing with certain economic problems.
Changing relative shares of different elements in the population from time to time have an important
bearing on the fluctuations of economic activity, and on the personal inequality of incomes, which
has much to do with economic welfare.
3. Net Domestic product at Factor Cost (NDP)
Net domestic product at factor cost is defined as that national production which is made by the
domestic factors of a country during the period of a year. In other words, we can get net domestic
product (At factor cost) if we deduct net income received from abroad from the net national product
at factor cost. Thus,
NDP at Factor Cost= NNP at Factor Cost – Net Income from Abroad
4. Personal Income (PI)

Personal income is the sum of all incomes actually received by all individuals or households during
a given year. National income (that is, total income earned during a year) is different from personal
income (That is, the income actually received by households). We know that all, which is produced
by industry and government, must necessarily belong to someone, and hence can be regarded as
national income received or accrued by the people (of the country), but not all of the value of this
product is paid to them as money income. Part of the net earnings of business firms are taken away
from them by government in the form of corporate income taxes excess profits taxes, and the like,
before being paid to the owners of the business firms. These are direct taxes that do not enter into
the prices of commodities. Further, many firms retain part of their earnings in the business, to make
addition to their plants or as a reserve for future emergencies, instead of distributing the entire

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profits to their shareholders. Therefore, these earnings are not allowed to receive in money all of
the salaries or wages that they earn. The government charges a withholding tax, which is used to
finance social security payments to the aged, the unemployed and certain other persons. Similarly,
the government make some other transfer payments to people of the country.

All these things create a difference between the total incomes received by individuals and the total
social income produced. We subtract from national income all undistributed corporate profits,
corporate income taxes and social security withholding taxes and then add transfer payments from
government and business firms directly to persons; the resulting figure will be the personal income.
Thus,
Personal Income (PI) = Net National Income – undivided corporate Profits –
Corporate Income Tax- Social Security Contribution + Transfer payments.
The above concept of personal income is useful for certain special purposes. For example, it shows
the ability of people to pay taxes. The personal income data are available on monthly basis whereas
the data for national product and national income are not published so frequently and, therefore, the
accurate idea cannot be drawn. This is the reason that personal income data are used for analysing
current changes in the economy.

5. Disposable Income (DI)

The main drawback of personal income is that they do not tell us how much is actually at the
disposable of people for their personal expenditure. For this we use the concept of disposable
income. After a good part of personal income is paid to government in the form of personal taxes
(such as income tax, property tax etc.), what remains of personal income is called Disposable
Income. Thus,

Disposable Income (DI) = Personal Income – Personal Taxes

Disposable income data are useful for studying the purchasing power of the consumers. Since
disposable income can either be consumed or it can be saved; with its help we may study of
consumption and saving that individuals make in the economy.
6. Real Income (RI)
When the national income is expressed in terms of the base year’s price index, it is known as Real
Income. Net National Income is the money value of the goods and services produced during a given

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year at the current prices. This figure does not indicate the real situation of the economy. Due to an
increase in the prices of goods and services, the figure for net national income may be high but real
production is not much. The reverse is also possible. To avoid this deficiency, we make use of the
concept of real income. It is calculated by the following formula:

𝑁𝑒𝑡𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑒 𝑎 𝑙𝑁𝑎𝑡𝑖𝑜𝑎𝑛𝑙𝐼𝑛𝑐𝑜𝑚𝑒 = × 100
𝑃𝑟 𝑖 𝑐𝑒𝐼𝑛𝑑𝑒𝑥𝐹𝑜𝑟𝑡ℎ𝑎𝑡𝑦𝑒𝑎𝑟

Income- Expenditure Approach

A Simple Economy Model

Assume an economy in which there is no government and foreign trade. In such case national
income accounts divide total expenditure into two categories (Note that in the simplest form of a
circular flow, output is equals to income that in turn equals to expenditure.): Consumption (C) and
investment spending (I).

➢ The first key identity is that between output produced and sold.
➢ Output sold can be written in terms of the components of demand as the sum of consumption
and investment spending.
➢ Accordingly, we can write the identity of output produced and output sold:

Y  C + I---------------------------------- [1]
Since there is no government and external sector in our economy (by assumption), the private sector
receives the whole of the disposable income (Y). The income will be partly spent on consumption
and partly will be saved. Thus, we can write

Y  C + S-------------------------------- [2)

Identity (2) tells us that the whole of income is allocated to either consumption or saving. Next,
identity (1) and (2) can be combined to give us
C + I  Y  C + S-------------------------- [3]
The left-hand side of identity (3) shows the components of demand, and the right-hand sides show
the allocation of income.

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Identity (3) can be reformulated to let us look at the relationship between saving and investment.
Subtracting consumption from each part of identity (3), we have

I  Y - C  S-------------------------------- [4)
Identity (4) shows that in this simple economy investment is identically equals savings.

An Economy with Government and Foreign Trade

We denote the government purchases of all goods and services by (G) and its tax receipt by (TA).
The government also makes transfer to the private sector (TR). The foreign sector is composed on
imports (M) and exports (X). Net exports (exports minus imports) are denoted by NX.

With government and foreign trade, identity (1) can be rewritten by adding G and NX- i.e.
Y  C + I + G + NX---------------------------- [5]
Now we have to recognize that part of income is spent on taxes and that the private sector receives
net transfers (TR) in addition to national income. Disposable income (YD) is thus equal to income
plus transfers less taxes:

YD Y + TR - TA------------------------------- [6]
Disposable income, in turn, is allocated to consumption and saving:
YD  C + S--------------------------------------- [7]
Combining (6) and (7), se have:

C + S  YD  Y + TR - TA--------------------- [8]
Or
C  YD - S  Y + TR – TA - S------------------- [8a]

Identity (8a) states that consumption is disposable income less saving or, alternatively, that
consumption is equal to income plus transfers less taxes and saving.
Substituting the right-hand side of (8a) into (5) and rearranging, we get
S - I  (G + TA - TR) + NX--------------------- [9]
The first term on the right-hand side (G+TA-TR) is the government budget deficit- i.e., the excess
of government spending over its receipts. The second term on the right-hand side is the excess of
exports over imports, or net exports.

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➢ Thus, identity (9) states that the excess of saving over investment (S – I) of the private sector is
equal to the government budget deficit plus the trade surplus
➢ The identity suggests that there are important relations among the excess of private saving over
investment (S–I), the government budget (G+TA-TR), and the external sector.
➢ For instance, if, for the private sector, saving is equal to investment, then the government’s
budget deficit (surplus) is reflected in an equal external deficit (surplus).

In the 1980s there was much discussion of the twin deficit- the budget deficit and the trade deficit.
Identity (9) is helpful is seeing that budget deficit must have a counterpart: if the government spends
more than it receives in revenue, then it has to borrow, either at home (private saving exceeds
investment) or abroad (imports exceeded exports). The identity makes it clear that budget deficits
need not be matched one-for-one by negative net exports. Thus, there is no inevitable one-to-one
link between the two deficits.

Self-test

1. What is National Income?

2. What are the National Income Accounts?
3. Discuss the Approach in Measuring GDP/GNP?
4. What are the limitations of National Income Accounts
5. Discuss the Difference between GNP and GDP

2.6. The GDP Deflator and the Consumer Price Index

Price of a Basket of Goods

One birr today doesn’t buy as much as it did 10 or 5 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 policy makers.

Dear learner! Do you know how the cost of living is measured?------------------------------

---------------------------------------------------------------------------------------------------- Excellent!

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The most commonly used measure of the level of prices is the consumer price index (CPI). The
Statistical Authority has a 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 in to a single
number measuring the value of production, the CPI turns the prices of many goods and services in
to a single index measuring the overall level of prices.

But how should economists aggregate the many prices in the economy in to a single price index
that reliably measure the price level?

They could simply compute an average of all prices. Yet this approach would treat all goods and
services equally. Because people might buy more of product X than product Y. Product X should
have a greater weight in the CPI than the price of Y. The statistical authority 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.

Illustration

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

(5  Current price of Apples) + (2  Current price of Oranges)

CPI =
(5  2006 Pr ice of Apples) + (2  2006 Pr ice of Oranges)

In this CPI, 2006 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 costs to buy the same basket of fruit in 2006.

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.

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2.7. The CPI versus the GDP Deflator

Another measure of price is GDP Deflator that is the implicit price deflator for GDP, which can be
calculated as the ratio of nominal GDP to real GDP. The GDP deflator is a measure of the general
price level.
Nominal GDP
GDP Deflator =
Real GDP

Dear learner! Do you know the difference between real and Nominal GDP? ---------------
---------------------------------------------------------------------------------------------- Very good!

2.8. Nominal versus Real GDP

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

➢ GDP measured at current prices is known as nominal GDP.

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

➢ 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 Ethiopia affects the CPI,
because consumers buy the Toyota, but it does not affect the GDP deflator.

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➢ 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 remains 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.

The consumer price index is a closely watched measure of inflation. Policymakers in the Federal
Reserve monitor the CPI when choosing monetary policy. In addition, many laws and private
contracts have cost-of-living allowances, called COLAS, which use the CPI to adjust for changes
in the price level. For instance, social security benefits are adjusted automatically every year so that
inflation will not erode the living standard of the elderly. Many economists believe that CPI tends
to overstate inflation the reasons are:

➢ Because the CPI measures the price of a fixed basket of goods, it does not reflect the ability of
consumers to substitute toward goods whose relative prices have fallen. Thus, when relative
prices change, the true cost of living rises less rapidly than the CPI.
➢ A second problem is the introduction of new goods. When a new good is introduced in to the
marketplace, consumers are better off, because they have more products from which to choose.
In effect, the introduction of new goods increases the real value of the dollar. Yet this increase
in the purchasing power of the dollar is not reflected in a lower CPI.
➢ A third problem is unmeasured changes in quality. When a firm changes the quality of a good
it sells, not all of the good’s price change reflects a change in the cost of living. Many changes
in quality, such as comfort or safety, are hard to measure. If unmeasured quality improvement
(rather than unmeasured quality deterioration) is typical, then the measured CPI rises faster than
it should.

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Self-test
1. Explain the key difference between GDP deflator and Consumer Price Index (CPI) in the
measurement of the general price level i.e., cost of living.
2. What are the limitations of CPI as a measure of cost of living?
3. Discuss the difference between real and nominal GDP?

2.9. The Business Cycle

Dear Learner! What relationship should we expect to find between macroeconomic variables?

Inflation, growth, and unemployment are related through the business cycle. The business cycle is
the more or less regular pattern of expansion (recovery) and contraction (recession) in economic
activity around the path of trend growth. At a cyclical peak, economic activity is high relative to
trend; and at a cyclical trough, the low point in economic activity is reached. Inflation, growth, and
unemployment all have clear cyclical patterns.

In short, business cycle shows us the ups and downs of country’s GDP.

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Figure 2:1 Business cycle

The trend path of GDP is the path GDP would take if factors of production were fully employed.
Over time, real GDP changes for the two reasons.

➢ First, more resources become available which allows the economy to produce more goods
and services, resulting in a rising trend level of output.
➢ Second, factors are not fully employed all the time. Thus, increasing capacity utilization can
increase output.

Output is not always at its trend level, that is, the level corresponding to full employment of the
factors of production. Rather output fluctuates around the trend level. During expansion (or
recovery) the employment of factors of production increased, and that is a source of increased
production. Conversely, during recession unemployment increases and less output are produced
than can in fact be produced with the existing resources and technology. Deviations of output
from trend are referred to as the output gap.

The output gap measures the gap between actual output and the output the economy could produce
at full employment given the existing resources. Full employment output is also called potential
output.
Output gappotential output – actual output

When looking at the business cycle fluctuation, one question that naturally arises is whether
expansions give way inevitably to old age, or whether they are instead brought to an end by policy
mistakes. Often a long expansion reduces unemployment too much; causes inflationary pressures,
and therefore triggers policies to fight inflation- and such policies usually create recessions.

Dear learner! What relationship should we expect to find between unemployment and real
GDP?------------------------------------------------------------------------------------------------------------
----------------------------------------- Excellent!

Because employed workers help to produce goods and services and unemployed workers do not,
increases in the unemployment rate should be associated with decreases in real GDP. This negative
relationship between unemployment and GDP is called Okun’s Law.

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Okun’s Law

A relationship between real growth and changes in the unemployment rate is known as Okun’s
law, named after its discoverer, Arthur Okun. Okun’s law says that the unemployment rate declines
when growth is above the trend rate.
u = -x (ya – yt)

Where u is change in unemployment, x the magnitude in which unemployment declines due to a

percentage point growth, ya actual growth rate of output, and yt is trend output growth rate.

The figure below shows the Okun’s law relationship between unemployment and growth in output.

Growth and Unemployment Dynamics

12
Percentage change in real GDP

0
-3 -2 -1 0 1 2 3

-3
Change in unemployment rate

Figure 2.2 Growth and Unemployment Dynamics

2.10. Unemployment and Inflation

[Link] Unemployment Rate

One aspect of economic performance is how well an economy uses its resources. Because an
economy’s workers are its chief resource, keeping workers employed is a dominant concern of
economic policy makers.

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Dear learner! Can you guess what the difference between employed and unemployed is? -------
-------------------------------------------------------------------------------------------------------------------
---------------------------Exactly!

Unemployed: A person who is willing to have a job and seeking it but couldn’t find the job.

Employed: Is a person who has a job and actively participate at a paid job.

Dear learner! Having the concept unemployment now let us discuss how the rate of unemployment
is measured. Then unemployment rate is the statistic that measures the percentage of those people
wanting to work who do not have jobs.

Numberofunemployed
UnemploymentRate =  100
Labourforce

The labour force is defined as the sum of the employed and unemployed, and the unemployment
rate is defined as the percentage of the labour force that is unemployed.

Labour Force = Number of Employed + Number of Unemployed

A related statistics is the Labour-force-participation Rate, the percentage of the adult population
that is in the labour force:

Labour Force
Labour − Force Particiaption Rate =  100
Adult Population

Illustration
Spouses the Statistical Authority in Ethiopia have the following result from the census taken in
1994. The number of unemployed is 45 billion, employed 20 billion and adult population 50
million.
Find
1. Unemployment Rate
2. Labour-Force Participation rate

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Solution

To find the unemployment rate first we need to have the Labour Force;

Labour Force= Unemployed + Employed

= 45 billion + 20 billion
= 65 billion
Then;
Number of unemployed
Unemployment Rate =  100
Labour force
45billion
UnemploymentRate = 100 = 0.6923%
65billion
Labour-Force participation rate can be also calculated as follows:

LabourForce
Labour − ForceParticiaptionRate =  100
AdultPopulation
65billion
Labour − ForceParticiaptionRate =  100 = 1.3%
50billion

[Link] –Unemployment Dynamics

Dear learner! What relationship should we expect to find between unemployment and
inflation?-------------------------------------------------------------------------------------------------------
---------------------------------------------- Good!

The Phillips curve describes the empirical relationship between inflation and unemployment: the
higher the rate of unemployment, the lower the rate of inflation. The curve suggests that less
unemployment can always be attained by incurring more inflation and that the inflation rate can
always be reduced by incurring the costs of more unemployment. In other words, the curve suggests
there is a trade-off between inflation and unemployment.

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Figure 2.3 Phillips curve

Self-test: discussion question

1. Briefly explain the NIA.
2. What is the difference between real GDP and nominal GDP
3. Briefly explain the precautions should be made while calculating GDP
4. What are the three approaches of measuring GDP?
5. What are the shortcomings of GDP or GNP?
6. Use a graph and explain the Okun’s law.
7. What is Philips curve?
8. Define business cycle and explain the positive and negative factors for the fluctuations of
economy across the time.
9. Given the data of a hypothetical country, for the year ended December 2021 as follow, calculate:
a. GDP at market price
b. GDP at factor cost
c. GNP at factor cost
d. National Product/National Income
e. GNP at market price
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Items ETB (Million)

Banking and insurance services 470
Agricultural and fishing 140
Mining 290
Construction 760
Forestry 190
Manufacturing 820
Other services 300
Depreciation 130
Taxes on expenditure 290
Subsidies 340
Factor income from abroad 530
Factor payment to abroad 600

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Unit summary

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.

There are different ways of measuring the national income of the country. Among them GDP is
the mostly widely used ways of measurement.

GDP is the total value of all final goods and services produced in the economy in a given time
period (note that GDP is a flow not a stock).

GNP GDP is the total value of all final goods and services produced by the citizens of the country
during the year.

There are three approaches of measuring GDP; value added approach, expenditure approach, and
income approach.

Using expenditure approach, GDP = C+I+G+X-M

Using income approach, GDP is summation of wages and salaries of the employees (or
compensation to employees), Incomes of non-company business, Rental incomes of persons,
corporate profits, and Incomes from Interest.

Real GDP uses base year price while nominal GDP uses current year price.

The business cycle is the more or less regular pattern of expansion (recovery) and contraction
(recession) in economic activity around the path of trend growth.

There are four phases of business cycle, namely; peak (Boom), recession (Contraction), trough
(bottom), and recovery (expansion).

Okun’s law shows the negative relationship between real growth and changes in the unemployment
rate.
The Phillips curve describes the empirical relationship between inflation and unemployment: the
higher the rate of unemployment, the lower the rate of inflation.

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UNIT THREE: AGGREGATE DEMAND ANALYSIS

3.1. Unit introduction
Dear learner! In the first two units we have seen about macroeconomics and the major
macroeconomic variables; we have also discussed how the national income is measured. Now in
this unit we continue our study of economic fluctuations by looking more closely at aggregate
demand. Our goal is to identify the variables that shift the aggregate demand curve, causing
fluctuation in national income.

The model of aggregate demand developed in this unit, called the IS-LM model is the leading
interpretation of Keynes’s theory. The goal of the model is to show what determines national
income for any given price level. There are two ways to view this exercise. We can view the IS-
LM model as showing what causes income to change in the short run when the price level is fixed.
Or we can view the model as showing what causes the aggregate demand curve to shift.

The two parts of the IS-LM model are, not surprising, 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’ and ‘money’, and the LM curve represents what’s happening
to the supply and demand for money. Because the interest rate influences both investment and
money demand, it is the variable that links the two halves of the IS-LM model. The 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.

Objectives:

At the end of this unit, you will be able to know:

➢ Goods market and IS curve
➢ Money market and LM curve
➢ Equilibrium in Goods and Money Market
➢ Derivation of the aggregate demand curve
➢ Fiscal and Monetary Policy in IS-LM Model

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3.2. The Goods Market and the IS Curve

3.2.1. Construction of the IS curve
The IS curve/schedule is one that shows the combination of the interest rate and income that reflects
equilibrium condition in the goods market. The product market equilibrium condition is obtained
at a point where planned aggregate demand is equal to output/income, i.e.

Y = C + I + G…………………………………….…. (1)
And Y = C + S + T…………………………………… (2)
 C+S+T=C+I+G
S + T = I + G……………………………………. (3)

To find the set of interest rate and income level combinations that produces equilibrium, equilibrium
for the product market, a simplified and more general case is considered.

The simplified case

The government sector is neglected, i.e.,G = T = O, then equation (3) can be written as

I(r) = S(y) …………………….…………………. (4)

Where; the prevailing market interest rate and that of saving by the level of income determine the
level of investment. So, while investment is plotted as a negative function of interest rate, saving is
plotted against income, with a positive MPS slope. The level of interest rate and the level of income
that equates equation (4) will give us the IS curve, the label of which is obtained from this simple
version.

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If the investment schedule is given by I(r) curve and the saving function is given by S(Y), the IS
curve can be derived by taking different values of the interest rates. Take the interest rate r1, the
corresponding investment level, which is determined by the investment schedule at point C in the
upper left diagram, is I1. If the goods market is in equilibrium, the economy will exhibit a condition
that can be explained by the 45o line, i.e. I1 = S1. It means that for the I1 level of saving the goods
market will become equilibrium at S1 level of saving. S1 level of saving is attained at Y1 level of
income, which is located in the lower right diagram. Point C in the north-east corner of the diagram
is the combination of Y1 level of income and r1 interest rate. Thus, Y1 is the equilibrium level of
output when the interest rate is r1.

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If the interest rate rises from r1 to r2, the level of investment will decline to I2, which is located at
point A in the northwest diagram. The level of saving that equilibrates the goods market is given
by the 450 lines, i.e., S2. In order to save S2 level of saving the economy needs to have an income
level of Y2. The combination of r2 and Y2 gives rise to point A in the upper right diagram. The
equilibrium level of output decreases from Y1 to Y2 when the interest rate rises from r1 to r2. The
curve thus formed represents the negatively sloped IS curve.

3.2.2. What determines the slope of the IS curve?

1. The slope of the investment function: - When the slope of the investment schedule is steep (flat),
where investment is not very sensitive (more sensitive) to movements in the interest rate, the interest
elasticity of investment demand is low (high). In the former case, investment is relatively insensitive
to changes in the interest rate, I is small consequently S and Y are very small. The IS curve
will be kept steep, and vice versa. When the investment function is steep, I’(r), the IS curve will
bear a steep curve which is given by IS’ in the r-Y plane. When the investment function is flat, I”
(r), the IS curve will have a flat shape, IS”.
2. The slope of the saving function: - The slope, which is given by the value of the MPS, will be
steeper, the higher the value of the MPS. If the slope of the investment schedule is unchanged, a
given decline of the interest rate leads to a given increase in investment. Thus, saving must increase
by this same amount to maintain the product market equilibrium. The increase in income that
generates this new saving increment will be lower because of high MPS value. Thus, the IS curve
will become relatively steeper.

3.2.3. What factors shift the IS schedule?

Let us consider the general case where the government sector is included to make the economy a
closed one. The equilibrium condition in the product market is thus given by

I(r) + G = S(Y-T) + T………………………………. (5)

Saving function is now given as a function of disposable income, Yd=Y, because of the introduction
of the variable G, the level of spending, I(r) + G, is a schedule that represents the aggregate demand
and lies to the right of I(r) schedule by the fixed amount of G and the saving plus tax schedule, S(Y-
T) + T, represents the national income and lies above the saving function by a fixed amount of T,
which is exogenously determined.

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The IS curve will shift because of:

A. Changes in government spending: - when the government spending increases, the IS curve
shifts outward.
Initially,
▪ The government spending was G0, and at r0 interest rate government spending and
investment spending was I0+G0
▪ The income level of Y0 generates saving plus tax equivalent with I0+G0 (S0+T=I0+G0)
▪ IS0 was the product equilibrium schedule at r0and Y0 levels

Dear students: can you describe the factors in which the slope of IS curve is depending on? ----
----------------------------------------------------------------------------------------------- Very good!
When the government spending increases from G0 to G1

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▪ At a given r investment will be unchanged but the investment plus government spending
schedule shifts to the right and the sum of the spending will be higher by the increase in
government spending
• G=G1-G0
▪ The product market equilibrium equates this higher level of I0+G1 with higher level of saving
plus taxes, S3+T, which is generated through the higher level of income, Y3.
▪ A given interest rate, r0, together with a higher level of income, Y3, will form the product market
equilibrium schedule, IS1 (shifts to the right of IS0)
▪ An increase in the government spending shifts the IS schedule to the right
B. Changes in Taxes

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Initially,
▪ Taxes equal to T0
▪ At the r0, the level of government and investment spending along the I(r) + G schedule is at
I0+G0, which is equated with the saving plus taxes level, S0+T, at the product market equilibrium
(the 450 line)
▪ This requires the income level of Y0
▪ The corresponding level of r0 and Y0 in the IS schedule is plotted at point A

When taxes increase from T0 to T1

▪ At a given interest rate, r0, the product market equilibrium needs the level of income at which
the total saving plus taxes remains unchanged because I0+G0 is not changed
▪ Higher level of taxes should be offset by a reduction in saving and hence in the level of income
to maintain the unchanged equality
▪ The corresponding equilibrium level of income Y2 and interest rate r0 is plotted at point B in
the IS curve (the curve shifts inwards to IS1)
 An increase in taxes shifts the IS curve to the left

C. Autonomous Changes in Investment

A favorable expectation about the future profitability of investment projects increases the level of
investment demand corresponding to each interest rate. Consequently, it leases to:

 Shifting the I(r) schedule upward

 Shifting the investment plus government spending schedule to the right by the amount
of autonomous investment increase
 The increase in autonomous investment spending shits the IS curve rightward

The General Case for Taxes

When taxes are partly collected on the basis of direct incomes, taxes become a function of income
written as
T=T(Y)……………………………………. (6)

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In this case, the slope of the S(Y-T) +T(Y) schedule changes in accordance with the multiplier of
the MPS. The resulting IS curve will be reliant on the slope of the former schedule.
3.2.4. Mathematical Representation of the IS Curve
(1) The slope of the IS schedule

Using equations (5) and (6) the product market equilibrium condition of the IS curve is

I (r ) + G = S (Y − T (Y )) + T (Y ).....................................................(7)
and the consumption functionis proposed as
C = a + cYd ................................................................(8)
a − the effect on consumption of var iables other than income
c − MPC, the increasein consumer exp enditure per unit increaseinYd
o  c 1
Yd − disposableincome, income net tax payments
Yd = Y − T .................................................................(9)
according to the definitionof naional income
Y  C + S + T ...........................................................(10)
from (9) and (10)
Yd  Y − T  C + S ....................................................(11)
from (8) and (11)
S = −a + (1 − c)Yd .......................................................(12)
0  1− c  1
1 − c is the m arg inal propensity to save
S = −a + (1 − c)(Y − T (Y ))..........................................(13)
U sin g (7) and (13)
I (r ) + G = S (Y − T (Y )) + T (Y )
I (r ) + G = −a + (1 − c)(Y − T (Y )) + T (Y )................................(14)
by taking the total differentiation
i dr = dy − t dy − c (dy − t dy ) + t dy
i dr = (1 − c (1 − t ))dy
dr (1 − c (1 − t ))
= 0
dy i

Slope of IS curve can be summarized shortly as

➢ It is negatively sloped

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➢ It is steeper when the MPS, given by (1 − c(1 − t )) , is higher or when the interest
elasticity of investment is relatively insensitive
➢ It is steeper when marginal tax revenue, t’, is higher

3.2.5. Factors that shift the IS curve

By equation (14) we have

I (r ) + G = −a + (1 − c)(Y − T (Y )) + T (Y )
And if I(r) and T(Y) have autonomous (exogenous) components given as

I (r ) = I + i (r )
T (Y ) = T + tY
Where I and T are exogenous / autonomous components
I + i (r ) + G = −a + (1 − c)Y − (1 − c)[T + tY ] + [T + tY ]
(1 − c)Y = a + I + G + i (r ) + (1 − c)[T + tY ] − [T + tY ]
(1 − c)Y = a + I + G − c(T + tY ) + i (r )

Y=
1
1− c
 
a + I + G − cT − c(tY ) +
1
1− c
i(r )

Thus, the magnitude of the IS curve shift is given as follows. For the change in the autonomous
spending of consumption a, government spending, G, and investment I and, the IS curve shifts to
the right. The effect is identical and the magnitude is given by

dy dy dy 1
= = = 0
da dg dI 1 − c

For the change in exogenous taxes, the effect on IS schedule is given by

dy −c
= 0
dT 1 − c

The IS schedule shifts leftward. But if we re-specify the investment function and tax functions as

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I (r ) = I − br
T (Y ) = tY
We can rewrite(14) as
I − br + G = −a + (1 − c)(Y − tY ) + tY
a + I + G − br = [(1 − c)(1 − t ) + t ]Y
= [(1 − t ) − c(1 − t ) + t ]Y
= [1 − c(1 − t )]Y

Y=
1
1 − c(1 − t )

a + I + G − br 
if A = a + I + G and

1
=
1 − c(1 − t )
Y =  [ A − br ]

3.3. The Keynesian Cross

Dear learner! We have seen from the above that the IS curve plots the relationship between the
interest rate and the level of income that arises in the market for goods and services. We can also
develop this relationship by another method below; 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.

Keynes proposed that an economy’s total income was, 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 recession and
depression, according to Keynes, was inadequate spending.

To derive the Keynesian cross, we begin by looking at a distinction between actual and planed
expenditure.

➢ Actual expenditure is the amount households, firms and the government spend on goods
and services and it is equal to GDP.

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➢ Planned expenditure (or planned aggregate demand) is the number of households, firms,
and the government plan to spend on goods and services.

Dear learner! Can you guess why actual expenditure ever differs from planned expenditure? --
-------------------------------------------------------------------------------------------------------------------
------------------------------Very good!

The answer is that firms might engage in unplanned inventory investment because their sales do
not meet their expectations. The difference between actual and planned expenditure is unplanned
inventory investment. When firms sell less of their product than planned, their stock of inventories
automatically rises. Conversely, when firms sell more than planned their stock of inventories will
falls. Because these unplanned changes in inventory are counted as spending by firms, actual
expenditure can be either above or below planned expenditure.

Now consider the determinants of planned expenditure. Assuming that the economy is closed, so
that net exports are zero, we write planned aggregate demand (or planned expenditure) AD as the
sum of consumption (C), planned investment (I), and government purchases G:

AD = C+I+G------------------------------------ [1]
The above equation states that consumption depends on disposable income (Y-T), which is total
income Y minus taxes T.
C=C (Y-T) --------------------------------------- [2]
To keep things simple, for now we take planned investment as exogenously fixed.

I = I . -------------------------------------- (3)

And that the levels of government purchases and taxes are also fixed.

G = G , -------------------------------- (4)

T = T . ---------------------------------- (5)

Combining these equations, we obtain

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AD = C(Y − T) + I + G . ------------------------ (6)

Equation [6] states that planned aggregate demand (planned expenditure) is a function of income

Y, the exogenous level of planned investment I , and the exogenous fiscal policy variables G and T
.

AD AD = C(Y − T) + I + G

MPC

0 Income, output (Y)

Figure 3.4. Planned expenditure a function of income

The figure above graphs planned expenditure as a function of the level of income since the other
variables are fixed. The line slopes upward because higher income leads to higher consumption
and thus higher planned expenditure. The slope of this line is the marginal propensity to consume,
the MPC: it shows how much planned expenditure increases when income rises by one unit.

Proof: 𝐴𝐷 = 𝐶(𝑌 − 𝑇) + 𝐼 + 𝐺

d ( AD) dC (Y − T ) d I d G
= + +
dY dY dY dY

Since the T, G and I are constants

d ( AD) dC (Y )
=
MPC= dY dY ; which is the marginal propensity to consume

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The Economy in Equilibrium

The economy is in equilibrium when actual aggregate demand equals planned aggregate demand.
Total output of the economy Y equals not only total income but also actual aggregate demand. 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. We can write the equilibrium condition as Actual aggregate
demand = Planned aggregate demand (Y= AD)

Figuer 3.5: Keynesians cross

In figure 3.5 the 45o line serves as a reference line that translates any horizontal distance into an
equal vertical distance. Thus, anywhere on the 45o line, the level of aggregate demand is equal to
the level of output. For instance, at point A, both output and aggregate demand are equal.

Dear learner! How does the economy get to the equilibrium? ----------------------------------------
----------------------------------------------------------------------------------------------------- Excellent!
In this model, inventories play an important role in the adjustment process. The equilibrium output
would be achieved through inventory adjustment. Unplanned changes in inventories induce firms
to change production levels, which in turn changes income and expenditure.

For example, suppose GDP is at a level greater than equilibrium level, such as level Y1 in figure
3.5 because of the miscalculation of firms about the aggregate demand. In this case, planned
aggregate demand AD1 is less than production (Y1). Firms are selling less than they produce. Firms

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add the unsold goods to their stock of inventories. This unplanned rise in inventories induces firms
to lay off workers and reduce production, which reduce GDP. This process of unintended inventory
accumulation and falling income continues until income falls to the equilibrium level. At the
equilibrium (at point A), where income equals planned aggregate demand.

Similarly, suppose GDP is at a level lower than the equilibrium level, such as the level Y 2. In this
case, planned aggregate demand is AD2, which is more than output Y2. Because planned aggregate
demand exceeds production, firms are selling more than they are producing. As firms see their stock
of inventories fall, they hire more workers and increase production. This process continues until
income equals planned aggregate demand.

In summary, the Keynesian cross shows how income Y is determined for given levels of planned
investment (I) and fiscal policy G and T. We can use this model to show how income changes when
one of these exogenous variables’ changes.

3.3.1. Fiscal Policy and the Multiplier: Government Purchases

Dear learner! Can you guess how changes in government purchase affect the economy?
-------------------------------------------------------------------------------------------------------------------
-------------------------------- Good Job!

Since government purchases are one component of expenditure, high government purchases imply,
for any given level of income, higher planned aggregate demand. If government purchases rise by
G, then the planned aggregate demand schedule shifts upward by G, as shown in the figure
below.

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Figure 3.6: An increase in government purchase in the Keynesian cross

The graph shows that an increase in government purchases leads to an even greater increase in
income. That is, Y >G. The ratio Y/G is called the government purchase multiplier; and it
tells how much income rises in response to a one-unit increase in government purchases. An
implication of the Keynesian cross is that the government purchases multiplier is larger than one.

Dear Learner! Why does fiscal policy have a multiplied effect on income? ------------------------
----------------------------------------------------------------------------------------------------- well done!

The reason is that, according to the consumption function, higher income causes higher
consumption. Because an increase in government purchases raises income, it also raises
consumption, which further raises consumption, and so on. Therefore, in this model, an increase in
government purchases causes a greater increase in income.

Illustration of the multiplier process

G Y C Y C…

The process of the multiplier begins:

➢ When expenditure rises by G, which implies that income rises by G as well.

➢ This increase in income in turn raises consumption by MPC  G, where MPC is the
marginal propensity to consume.

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➢ This increase in consumption raises aggregate demand and income once again.

➢ This second increase in income of MPC  G again raises consumption by MPC  (MPC
 G), which again raises aggregate demand and income, and so on.

We can thus write this process compactly as

Y= G + MPC  G + MPC2  G + MPC3  G + …

= (1 + MPC + MPC2 + MPC3 +…)  G
The government purchase multiplies is Y/G = 1 + MPC + MPC2 + MPC3 +…

This expression for the multiplier is an example of an infinite geometric series. A result from
𝟏
algebra allows us to write the multiplies as Y/G =𝟏−𝑴𝑷𝑪.

Mathematical note: infinite geometric series

Let z= 1 +x +x2 + …

Multiply both sides of this equation by x:

xz = x+x2 + x3 + …
Subtract the second equation from the first:
z-xz = 1 ➔ z (1-x) =1
This implies z = 1/1-x

We can also derive the multiplier from our national income identity
Y = C (Y-T) + I +G-------------------------- [1]
Assuming T and I are constant and totally differentiating [1], we would get

dY = C’ (dY) + dG--------------------------[2)
By a simple rearrangement of [2],

dG = dY – C’ (dY)
dG/dY = 1 – C’
𝟏
Taking the inverse of the above expression dY/dG = 𝟏−𝑪′

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Where C’ = dC/dY –i.e., MPC.

3.3.2. Fiscal Policy Multiplier: Taxes

Dear learner! Let us now consider how changes in taxes affect equilibrium income. A decrease in
taxes of T immediately raises disposable income Y-T by T and, therefore, consumption by MPC
 T. For any level of income Y, aggregate demand is now higher. As shown in the figure below,
the aggregate demand curve shifts upward by MPC  T. The equilibrium of the economy moves
from point A to point B and income rises from Y1 to Y2.

Figure 3.7: A decline in tax in the Keynesian cross

An increase in government purchases has a multiplied effect on income; so, does a decrease in taxes
(i.e., it has multiplier impact). Starting with the national income identity
Y= C (Y-T) + I + G
Assuming I and G to be constant, and differentiating the above expression we obtain

dY = C’ (dY – dT),
dY (1-C’) = -C’ dTs

And then rearranging to find

𝑑𝑌 𝐶′
= − 1−𝐶′< 0
𝑑𝑇

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Since C’ is MPC we can rewrite the tax multiplier as follows;

Y MPC
=−
T 1 − MPC

The multiplier implies that taxes and income are inversely related and a unit change in taxes increase
income by more than proportionately.
For example: If the marginal propensity to consume is 0.3, then the tax multiplier is

Y 0.3
=−
T 1 − 0.3
This is equal to -0.428.
In this example, a 1 birr cut in taxes raises equilibrium income by 0.428 birr.

3.4. The Interest rate, Investment and the IS Curve

The Keynesian cross is useful because it shows what determines the economy’s income for any
given level of planned investment. Yet it makes the unrealistic assumption that the level of planned
investment is fixed. However, planned investment depends negatively on the interest rate.
The transition from the Keynesian cross model to the IS curve is achieved by noting that if the real
interest rate changes, these changes planned investment. The Keynesian cross analysis tells us that
change in planned investment change GDP. Thus, for example, if interest rates increase, planned
investment falls, and so does output. Thus, higher levels of the interest rate are associated with
lower level of output.

To add the relationship between the interest rate and investment, we write the level of planned
investment as
I = I(r).
Thus, we can write equation [1] as

Y = C (Y-T) +I(r) +G

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We can now use the investment function and the Keynesian cross diagram to determine how income
changes when the interest rate changes. Because investment is inversely related to the interest rate,
an increase in the interest rate from r1 to r2 reduces the quality of investment form I (r1) to I (r2).
The reduction in planned investment, in turn, shifts the expenditure function downward as shown
in the upper panel of the figure above. The shift in the expenditure function leads to a lower level
of income. Hence, an increase in the interest rate lowers income.

The IS curve summarizes the relationship between the interest rate and the level of income that
results from the investment function and the Keynesian cross. The higher the interest rate; the lower
the level of planned investment; and thus, the lower level of income. For this reason, the IS curve
slopes downward.

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

3.5. The Money Market and the LM Curve

Dear learner! The second link in the chain, which proposes that the change in the money stock
affects the aggregate demand and income by changing the interest rate, deals with the relationship
between the quantity of money (money stock) and the rate of interest. The money stock includes
such assets as money and other deposits, bonds and stocks. The markets in which these assets are
traded form the asset (money) markets.

For macroeconomic analysis purpose these financial assets are classified into:

• money (currency and deposits on which checks can be drawn - demand deposits, travelers’
check and other checkable deposits); and
• bonds (all other money assets – bonds and equities (stock)

The analysis begins by some simplifying assumptions

1. Based on this grouping of the financial assets, all money pays no interest
2. Bonds are homogeneous and perpetuities/ console (with no repayment of principal)
R
V =
i
Where; v --The present value of the bond, i – The interest rate, and R – The interest paid per year
Bond is a promise by a borrower to pay a lender a certain amount (the principal) at a specified date
(the maturity date) and to pay a given amount of interest per specified time period in the meantime.
Governments, municipalities and corporations, can issue it with the interest rate reflecting the risk
of default.

How does an individual have to decide how to allocate his financial assets/wealth between
alternative types of assets? Such a decision is referred to as a portfolio decision: W= B+ M

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where; Bond holding (B) bears interest and Money holding (M) enables purchasing

The decision depends upon the equilibrium interest rate on bonds which is the rate at which the
demand for bond= the existing stock of bonds. What factors determine the equilibrium interest rate
of bonds?

The equilibrium interest rate can either be described as

• The rate at which the supply and the demand for bond (B) are equated,
• The rate that equates the demand for with the supply of money (M)

Assume that
• The supply of money and bonds are exogenously determined, i.e. the supply of money is
determined by the policies of central banks while that of bonds are by the investment
decisions of borrowers. The supply curve for B refers to the outstanding stocks
• The demand for M and B refers to the stock of money and the stock of B at a given point in
time

If we aggregate the demand for money and bonds of individuals and use the above assumption,
there are two equivalent ways of depicting the equilibrium interest rate.

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A person who is satisfied with the level of holding money relative to total wealth is satisfied with
the bond holdings, i.e. (s) he is at the optimal split of fixed wealth between M and B at 6% interest
rate. If there exists an excess demand for M at this rate of interest, in the aggregate, the public tries
to raise the proportion of their money holding. They, then, become willing to supply an equivalent
worth of B to the bond market. The bond supply becomes excess, which together with the fixed
supply of bonds, leads to a fall in the price of bonds. This raises the interest rates because of the
relationship that

R R
V =  r=
r V

Now as a result of the fall in the price of bonds the demand for bond for the existing bonds increases
and hence the demand function for bonds shifts up to Bd1 at a higher rate of interest until the bond
market clears. When it clears so does the money market at this higher interest rate at which the
demand for money = the supply of money. Thus, equilibrium in one market implies equilibrium in
another. For the purpose of macroeconomic analysis, the money market where the equilibrium
interest rate is related with the monetary factors is chosen. According to this market the equilibrium
rate of interest is determined by factors affecting the supply of money and the demand for money.

➢ The supply of money is determined by the policies of the central bank

➢ The demand for money is determined by factors explained by the theory of money demand

3.5.1. The Theory of Money Demand

Dear learner! Can you guess why peoples demand money? ------------------------------------------
---------------------------------------------------------------------------------------------------- Good job!
The demand for holding money relies on three motives: transaction, precautionary and speculative
motives.

(1) Transaction Demand

This demand type is derived from the transaction motives. Because of this motive, individuals and
firms hold money for use in transactions. As a medium of exchange, money bridges the time gap
between the receipt of income (monthly) and payments for expenditure (daily). As the volume of
transactions, for which income is a good measure, changes so do the amount of money held for

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such purpose positively. In addition to this expected expenditure transaction, individuals also hold
money for unexpected expenditure. The money demand for such motives is termed as precautionary
demand for money. Both the transaction and precautionary demand for money, being determined
by income, are subsumed under the transaction demand for money, of which function is given by:
transaction demand  k(y) and k(y)>0

(2) Speculative Demand

Dear learner! Why should an individual hold money above the needs for transaction and
precautionary motives? ------------------------------------------------- Good!
Even though bonds pay interest and money does not, there are times during which individuals prefer
to hold money rather than bonds. This usually happens when the individual believes that future
rates of interest will be above the current market interest rates, he has a reason for keeping actual
liquid cash rather than holding bonds.

The desire for holding speculative balances that arise from securing profit from unexpected future
capital losses on bonds depends on the rate of interest expected in future. How does expected future
interest rate affect current decision of speculative demand for money? At the time an individual
makes a decision whether to buy a bond or to hold money, he makes also expectations about future
interest rate, and i.e., he might expect that the interest rate will rise, fall or remain the same.
Case 1

If he expects that the rate of interest, as compared to its current rate, falls. Then he expects that the
expected future bond price,

𝑅
𝑉𝑒 = 𝑟 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1)
𝑒

Will rise above its current bond price,

𝑅
𝑉 = 𝑟 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2)

And he expects a capital gain,

𝑅 𝑅
𝐺 = 𝑉𝑒 − 𝑉 = 𝑟 − 𝑟 . . . . . . . . . . . . . . . . . . . . . . … … … . . . . . . . . . . . . . . . . . (3)
𝑒

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If capital gain is expressed as a percentage of its current value,

𝑉𝑒 −𝑉 𝑅⁄ −𝑅⁄ 𝑟
𝑟𝑒 𝑟
𝑔= = 𝑅⁄ = 𝑟 − 1. . . . . . . . . . . . . . . . . . . . . (4)
𝑉 𝑟 𝑒

If this expected capital gain is added to the interest payments the individual will receive after a year,
the expected net profit of bond holding will be

r
e=r+g =r+ − 1......................................(5)
re

Since for this individual whose expectation is formed on the falling interest rate the expected
earning is positive (e>0). He will decide to invest all his wealth in bonds.

Case 2
Suppose the individual expects that future interest rate rises in comparison to the current rate, then
what will be his decision? This expectation leads to the expectation that future expected bond price
will fall according to the relationship given by (1). Then he expects a capital loss,

r
(g) = −1  0
re

If this expected capital loss outweighs the interest earnings on bond holdings, r, i.e.

(g)>r  e<0

The individual expects a net loss no any bond he buys, then he will decide to hold his all wealth in
the form of money. We can conclude that given the rate of interest the individual expects, he will
desire to hold only money when the current rate of interest is low and only bonds when the rate is
high.

These cases show that the speculative demand for money depends on the relationship between
current interest rate (r) and expected interest rate (re). In other words, from (5) we have that

𝑟
𝑒 =𝑟+𝑟 −1
𝑒

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The capital gains;

𝑟
𝑔= −1
𝑟𝑒

Depends on the relationship between r and re. If r>re, the expected capital gain will be positive and
hence the expected yield will be net profit.

e=r+g>0

This implies that any profit maximizing individuals will hold his entire portfolio in the form of
bonds. On the other hand, if r<re the capital gain expected will be negative (capital loss). Adding
this capital loss with interest earning, r, the individual can arrive at either

a) A net profit if the interest earning outweigh the capital loss (r + g) >0 the decision in this
case will be bond holding
b) A net loss if the capital loss outweighs the interest earning (r + g) <0 the decision will be
money holding
c) No loss no gain, if the capital loss is equal to the interest earning (r + g) =0, the individual
will be indifferent in bond and money holdings
The Critical Interest Rate

Under the case where r<re, when the current interest rate falls significantly below the expected rate,
the expected capital loss will be large enough and exceed the current interest rate to produce
negative return in total. But if the current rate is slightly below the expected rate and the expected
capital loss exactly offsets the current interest rate (r), at this point of current interest rate (r +g) =
e = 0 and the individual becomes indifferent. This point is termed the critical interest rate.

It is described as;

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r
e = (r + g ) = r + ( − 1) = 0
re
1
r (1 + ) =1
re
1
r=
re + 1
rd
re
rc = ..........................................(6)
1 + re

And it lies below the expected rate of interest. It is possible to conclude that when

e>0, r>rc, capital gain is expected

The proportion of wealth held in the form of money is zero
e<0, r<rc, capital loss expected and outweigh the interest rate

The proportion of wealth held in the form of money is unity all the assets held in money
e=0, r=rc, both money and bond yield zero net return.
Graphically, the individual’s speculative demand for money can be given by the step function,
ABCD.

In aggregate the speculative balances will be smooth and continuous as we add the individual
speculative demand for money curves horizontally. Keynes assumed that different wealth holders
have different expected rates of interest and therefore different critical rates of interest. As a result

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of this difference, it becomes possible to draw the liquidity preference function for the economy as
a smooth curve. At a relatively high interest rate, only a few wealth holders have higher critical
interest rates.
Speculative demand for money l(r)
l(r)<0
Liquidity Trap

At a very low interest rate there is a general expectation of capital losses on bonds that substantially
outweigh the interest earnings. Bond prices are so high that wealth holders become indifferent
between holding bonds and holding money. Bonds and money become perfect substitutes. The
liquidity preference function is therefore in the liquidity trap.

M=l(r)

Speculative demand for money

Figure 3.11 Liquidity trap

The Total Money Demand
The transaction and precautionary demand for money vary positively with income while the
speculative demand for money is negatively related with the interest rate. Then, by putting them
together, we can write the total demand for money as

Md=L(Y,r)
Md=l(r) +k(y)………………………………... (7)
With l<0 and k>0

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NB: Both components of the total money demand, transaction and speculative, should be divided
by price to arrive at the demand for real balances

r r TB(y0) TB(y1) TB(y2) r

SB
r1 r1 r1

r2 r2 r2
r3 r3 r3

Md(y0)
Md(y1)
Md(y2)
Speculative dd Transaction dd money dd function

3.5.2. Money Supply

The amount of currency and demand deposit that constitutes the money supply of the economy is
exogenously determined by the central bank’s policies. So, the money supply is assumed to be a

controlled policy variable and taken as given at the level M . Given the price level P , the real money

supply is fixed at the level M P . Now by putting the money demand and money supply functions,
we will form the money market equilibrium condition as follows:

d
M M
= = l (r ) + k ( y)....................................................(8)
P P

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Excess supply

r0

r1

Md(y0)
M/P
Quantity of Money

Figure. 3.12. Money supply

Using the above diagram let’s consider the case when the fixed money stock shifts to the right
(increases). This, at the initial equilibrium interest rate, r0, results in the excess supply of money.
The resulting new money holding encourages people to buy bonds, whereby they reduce their
money holdings. The excess supply of money in the money market is changed into excess demand
for bonds in the bond market and pushes the price of bonds. Thus, this causes to lower the rate of
interest at which suppliers of bonds or borrowers offer to sell their bonds until a new equilibrium
interest rate is reached a r1, where the demand for money rises from (M/P)0 to (M/P)1

3.6. The LM Curve

3.6.1. The Construction of the LM Curve

According to the Keynesian model, the money demand is a positive function of income, due to the
transactions demand, and a negative function of rate of interest, due to the speculative demand for
money. This relationship for real balances can be described as given above in (7).

Along with the demand function for real balances, the money market assumes the exogenously
determined and independent of the interest rate money supply function. It is considered as a fixed
stock of money and has a vertical shape. In addition to this, if we assume the general price level is
fixed, then the real money supply is given by M/P. The equilibrium condition in the money market

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is given by the level of interest rate at which the demand function and the fixed supply function
equates as in (8)

r r

LM

r2 r2
r1 r1
r0 r0
L(y2)
L(y1)
L(y0)
M/P Y
M/P Y0 Y1 Y2

Figure 3.13 Derivation of LM curve

As income level increases, say from Y0to Y1 and to Y2, the money demand function shifts to the
right when plotted against the interest rate, say from L(Y0) to L(Y1) and to L(Y2). The value of the

fixed money stock being given at M P , the points of intersection in the money market show the
resulting increase in the interest rate say from r0 to r1 and then to r2, that maintains equilibrium in
the money market.

For each level of income, Y0, Y1 and Y2, it is possible to find the corresponding interest rates, r0, r1
and r2, at which the money market is in equilibrium. When these income-interest rate combinations,
(Y0, r0), (Y1, r1) and (Y2, r2) are plotted separately, the money market equilibrium, LM, schedule
will be constructed as shown above. Thus, LM schedule can be defined as a schedule that represents
the pairs of interest rate and income level that maintain the money market equilibrium at a given
level of money supply and price level.

The LM schedule is positively sloped, or upward to the right. It means that at higher levels of
income, equilibrium in the money market occurs at higher interest rates. The reason for such a result
lies in that the increase in income increases money demand at a given interest rate, because the

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transactions demand for money varies positively with income. But, since the money stock is fixedly
supplied, the money demand has to be restored to the equilibrium level by raising the interest rate.
This results in a lower speculative demand for money corresponding to the higher level of income.
The interest rate must rise until the fall in the speculative demand for money is just equal to initial
income- induced increase in transactions demand.

3.6.2. Factors Determining the Slope of the LM Schedule

The slope of the LM curve can be derived using (8) above, which states that

M
= l (r ) + k ( y )
P
by taking total differentiation
M  dl (r ) dk ( y )
d   = • dr + • dy
 P  dr dy
M 
0 = l dr + k dy d   = 0
 P
dr − k  incomeelasticityof money demand
= = ........................(9)
dy l int erest elasticityof money demand
Since k   0 and l   0, dr dy  0

From (9) it is easy to see that the higher the value of k, the responsiveness of money demand to
income, and the lower the value of l, the responsiveness on money demand to the interest rate, the
steeper will be the LM curve. (In other words, the higher the value of k, the larger the increase in

money demands per unit increase in income (M Y ) , and hence the larger upward adjustment in
the interest rate required to restore the money market equilibrium at higher level of interest rate.)
In order to maintain the slope of the money demand function at the level of the fixed supply of
money stock the interest rate will have to rise by enough to offset the income – induced increase in
money demand (for transaction purpose).

However, for a given income-induced increase in money demand (for a given k) the amount by
which the interest rate has to rise to offset this increase to restore equilibrium of the money market
depends on the interest elasticity of money demand or sensitivity of money demand to interest rate.
The lower the interest elasticity on money demand, the steeper the LM curve will be and the lesser

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will be the response of the demand for money to a given change in the interest rate. As income
increases from Y0 to Y1 and then to Y2 money demand schedule will shift to the right resulting from
the increases in the transactions demand for money.

Because a given increase in the interest rate will not reduce money demand by much, the interest
rate will have to rise by large amount to reduce money demand back to the fixed money supply
level. The LM curve will be steeper.

r r LM

r2 r2

r1 r1

r0 r0
L(Y2)
L(Y1)
L(Y0)
M y0 y1 y2 Y

When the money demand is highly interest – elastic, the money demand curve will become very
flat. This leads to the case where as the interest rate drops in a small amount, money demand
increases significantly. As income increases from Y0 to Y1 and from Y1 toY2, the income – induce
increase in money demand will be L(Y), L(Y1) and L(Y2). But, to restore the money market
equilibrium, the interest rate is required to rise by a relatively small amount that will offset the
income- induced increase in transactions balances. Consequently, the LM curve has relatively
become flat.

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r r

LM
r2 r2

r1 L(Y2) r1
r0 L(Y1) r0

L(Y0)
M y0 y1 y2 Y

3.6.3. Factors that Shift the LM Schedule

A policy action changing the policy instrument to a new level by increasing the money stock creates
an excess supply of money at the initial level of income and interest rate. Point A on the initial LN0
curve represents the point of money market equilibrium for an interest rate r0 an income level Y0
that are derived from the money market where the initial money supply Mo/P is equated with Ld(Y0)
schedules.

An increase in the real money supply from M0/P to M1/P reduces the equilibrium interest rate from
r0 to r1 to restore the money market equilibrium at Y0 level of income. With income fixed, for the
new higher real money supply to be equal to money demand, the interest rate must be lower to
increase the speculative demand for money. The combination of the given income level and the
new, lower interest rate that equilibrates the new real money supply with the money demand forms
the new LM schedule which lies below the initial LM0 curve, as shown at point B on the graph. In
short, at a given level of income the equilibrium interest rate has to be lower to induce people to
hold the larger real quantity of money for speculative purpose.

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r r LM0
LM1

r0 r0 A C

r1 r1 B
Ld(Y1)
L (Y0)
d

M Y
y0 y1

Alternatively, the new LM curve can be traced again by increasing the level of income for a given
interest rate, when the real money supply changes likewise. To maintain the money market
equilibrium, income would have to be higher to Y1, and hence for the given level of interest rate r0.
Through the transaction demand, the money demand schedule will shift out to Ld(Y1) to absorb the
higher real money supply. It is shown at point C on the new LM curve, LM1, which shifts rightward.

In short, an increase in the real money supply shifts the LM schedule downward and to the right.
Reversing the increase in the real money supply, for example increasing P, produces symmetrically
opposite result in the LM schedule that will shift upward and to the left.
Mathematically, we can derive the relationship as follows:

M
= m = l (r ) + k ( y )
P
M
d = dm = l dr + k dy
P
l dr = dm − k dy
dm k dy
dr = −
l l
dr 1
= 0
dm l 

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In general LM curve:

• It is the curve giving the combinations of values of income and the interest rate that produce
equilibrium in the money market
• It slopes upward to the right
• It will be relatively flat (steep) if the interest elasticity of money demand is relatively high
( low)
• It will shift downward (upward) to the right (left) with an increase (decrease) in the quantity
of money

Positions of the LM Curve

Consider the equilibrium point A, if we assume an increase in income from Y0 to Y1, then the
demand for money shifts from L (Y0) to L (Y1) at the initial interest rate r0. This turns out to be an
excess demand for money at point D.

r r M

Excess supply Excess supply

r1 C B r1 C B

r0 A D r0 A D
Excess demand Excess demand
L(Y1)
L(Y0) L
M Y
y0 y1

At this disequilibrium point there is an excess demand for money in the LM schedule too. More
generally, any point below and to the right of the LM schedule represents a disequilibrium ones and
excess demand for money. If excess supply of money exists in the money market, like at point C,
then correspondingly we have an excess supply of money in the LM schedule, where a
disequilibrium point C indicates this case. More generally, any point above and to the left of the
LM schedule indicates a disequilibrium point for excess supply of money.

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Dear learner! We get the LM curve, as it is the relationship between the interest rate and the level
of income that arises in the market for money balances. To understand this relationship, we begin
by looking at theory of the interest rate called the theory of liquidity preference.

3.7. The Theory of Liquidity Preference

The theory of liquidity preference explains how the supply and demand for real money balance
determines the interest rate.

Dear learner! To develop this theory, we begin with the supply of real money balances. If M stands
for the supply of money and P stands for the price level, then M/P is the supply of real money
balances. The theory of liquidity preference assumes there is a fixed supply of real balance. That

is, (M/P)s = M/ P .

The money supply M is an exogenous (external variable) policy variable chosen by the central bank.
The price level P is also an exogenous variable in this model. (We take the price level as given
because the IS-LM model considers the short run when the price level is fixed).

These assumptions imply that the supply of real balances is fixed and, in particular, does not depend
on the interest rate as shown in the figure below.

R Money Supply

M/ P M/P=real money balance

Figure.3.15. Money supply

Next, consider the demand for real money balances. People hold money because it is a “liquid”
asset- that is, because it is easily used to make transactions. The theory of liquidity preference
postulates that the quantity of real money balances demanded depends on the interest rate. The

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interest rate is the opportunity cost of holding money. When the interest rate rises, people want to
hold less of their wealth in the form of money.

We can write the demand for real money balances as:

(M/P)d = L(r),
Where the function L (r) shows that the liquidity of money demanded depends on the interest rate.
This equation states that the quantity of real balances demanded is a function of the interest rate.
This inverse relationship between money demand and interest rate can be shown as a downward
sloping demand curve.

L(r)
M/P
Figure.3.16. Money demand

To obtain the theory of the interest rate, we combine the supply and the demand for real money
balances. According to the theory of liquidity preference, the interest rate adjusts to equilibrate the
money market.

At the equilibrium interest rate, the quantity of real balances demanded equals the quantity supplied.
The equilibrium condition is shown in the figure below.

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Figure: 3.17: Theory of liquidity preference

Dear learner! How does the interest rate get to the above equilibrium of money supply and
money demand? --------------------------------------------------------------------------------------------
------------------------------------------------------------ very good!

The adjustment of the interest rate to this equilibrium of money supply and money demand occurs
because people try to adjust their portfolios of assets if the interest rate is not at the equilibrium
level.

➢ If the interest rate is too high, the quantity of real balances supplied exceeds the quantity
demanded. Banks and other financial institutes respond to this excess supply of money by
lowering the interest rates they offer.

➢ Conversely, if the interest rate is too low, so that the quantity of money demanded exceeds the
quantity supplied, individuals try to obtain money by making bank withdrawals, which drives
the interest rate up.

➢ At the equilibrium interest rate people are content with their portfolios of monetary and non-
monetary assets.

The theory of liquidity preference implies that decreases in the money supply raise the interest rate
and that increases in the money supply lower the interest rate. Suppose there is a reduction in money
supply. A reduction in M reduces M/P, since P is fixed in the model. The supply of real balances

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shifts to the left, as shown in the figure below. The equilibrium interest rate rises from r1 to r2. The
higher interest rate induces people to hold a smaller quantity of real money balances.

The opposite would occur if the central bank had suddenly increased the money supply. 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.

3.7.1. Income, Money Demand, and the LM Curve

Dear learner! So far, we have assumed that only the interest rate influences the quantity of real
balances demanded. More realistically, the level of income Y also affects money demand. When
income is high, expenditure is high, so people engage in more transactions that require the use of
money. Thus, greater income implies greater money demand. We now write the money demand
function as (M/P) d = L(r, Y).
The quantity of real money balances demanded is negatively related to the interest rate and
positively related to income.
Using the theory of liquidity preference, we can see what happens to the interest rate when the level
of income changes. For example, consider what happens when income increases from Y1 to Y2.

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As the above figure shows the increase in income shifts the money demand curve outward. To
equilibrate (to get equilibrium) the market for real money balances, the interest rate must rise from
r1 to r2. Therefore, higher income leads to a higher interest rate. The LM curve plots this relationship
between the level of income and the interest rate. The higher the level of income, the higher the
demand for real money balances and the higher the equilibrium interest rate. For this reason, the
LM curve slopes upward as illustrated above.

Definition: The LM curve represents a positive relationship between the interest rate and the level
of income that arises from equilibrium in the market for real money balance

3.7.2. How Monetary Policy Shifts the LM Curve

The LM curve tells us the interest rate that equilibrates the money market for any given level of
income. The theory of liquidity preference shows that the equilibrium interest rate depends on the
supply of real balances. The LM curve is drawn for a given supply of real money balances. If real
balances change, the LM curve will shift.

Suppose that the money supply is decreased from M1 to M2, which causes the supply of real
balances to fall from M1/P to M2/P. Holding constant the amount of income and thus the demand
curve for real balances, a reduction in the supply of real balances raises the interest rate that
equilibrates the money market. Hence, a decrease in real balances shifts the LM curve upward.

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In summary, the LM curve shows the relationship between the interest rate and the level of
income that arises in the market for real money balances. 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.

3.7.3. The Short-Run Equilibrium

We now have all the components of the IS-LM model. The two equations of this model are

Y= C (Y-T) + I(r) +G ---------IS

M/P = L(r, Y) ---------------------LM

The model takes fiscal policy, G and T, monetary policy M, and the price level P as exogenous.
Given these exogenous variables:
➢ The IS curve provides the combination of r and Y that satisfy the equation representing the
goods market, and
➢ The LM curve provides the combinations of r and Y that satisfy the equation representing
the money market.
These two curves are shown together in the figure below.

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The equilibrium of the economy is the point at which the IS curve and the LM curve cross. This
point gives the interest rate r* and the level of income Y* that satisfy both the goods market
equilibrium and the money market equilibrium condition. In other words, at this intersection, actual
expenditure equals planned expenditure, and the demand for real money balances equals the supply.

3.7.4. Monetary and Fiscal Policy Analysis

The intersection of the IS curve and the LM curve determines the level of national income. National
income fluctuates when one of these curves shifts, changing the short-run equilibrium of the
economy.

[Link]. Change in Fiscal Policy

Suppose that we start in equilibrium and that government spending is increased by G. Then the IS
curve shifts to the right. The increased spending increases income and, through the multiplier effects
from the circular flow, also increases consumption; income increases further. (Recall that the
rightward shift of the IS curve equals G/(1-MPC).) If we only had to worry about the goods
market, this would be the end of the story. But the increase in income, in turn, increases the demand
for money for transaction purposes (for purchasing of goods and services). This increased demand
for money forces up the interest rate, leading, in turn, to a decline in investment. Thus, we observe
short-run crowding out:

➢ The increase in GDP is less than the simple Keynesian cross model would have predicted
because that model omits changes in the interest rate.

➢ A decline in taxes, like an increase in government spending, shifts the IS curve out, causing
interest rates and GDP to rise.

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Mathematical derivation of the impact of Fiscal policy

IS: Y= C(Y-T) + i(r) + G----------------- [1]

LM: M/P = kY + Lr ---------------------- [2]

Differentiating [1] and [2], we obtain

dY = C’ (dY – dT) +i’dr + dG

Assuming the tax rate is fixed

dY = C’dY + i’dr + dG----------------[1.a]

Or
dY (1-C’) = i’dr + dG
From [2] we get

𝑑𝑚 𝑑𝑝
− 𝑚 𝑝2 = Ldr + kdY
𝑝
𝑑𝑚 𝑑𝑝 𝑘
dr = − 𝑚 𝐿𝑃2 − 𝐿 𝑑𝑌 ------------------[2.a]
𝐿𝑃

Substituting [2.a] into [1.a]

𝑖′ 𝑑𝑚 𝑑𝑃
𝑑𝑌 = 𝐶′𝑑𝑌 + ( − 𝑚 2 − 𝑘𝑑𝑌) + 𝑑𝐺
𝐿 𝑝 𝑃
1 𝑖′𝑑𝑚 𝑖′𝑚𝑑𝑃
𝑑𝑌 = 𝑖′𝑘 ( 𝐿′𝑃 − + 𝑑𝐺) ------------------- (3)
(1−𝐶′+ ) 𝐿′𝑃2
𝐿

𝑑𝑌 1
= 𝑖′𝑘 >0
𝑑𝐺 1−𝐶′+
𝐿

𝑖′𝑘
1-C’ >0 and > 0 since both the numerator and denominator are negative.
𝐿

Thus, government expenditure has expansionary impact.

[Link]. Changes in Monetary Policy

Consider the effects of an increase in the money supply. This shifts the LM curve out. The increased
money supply causes interest rates to fall in order to bring the demand for money in line with the
new higher supply. This fall in interest rates encourages investment, leading ultimately to an

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increase in GDP. Thus, interest rates are lower and GDP is higher. The linkage from a change in
the money supply to GDP is known as the monetary transmission mechanism.

Mathematical derivation of the impact of monetary policy

The impact of the monetary policy can also be derived from equation [3] above.

1 𝑖′𝑑𝑚 𝑖′𝑚𝑑𝑃
𝑑𝑌 = 𝑖′𝑘
( − + 𝑑𝐺)
(1 − 𝐶′ + 𝐿 ) 𝐿′𝑃 𝐿′𝑃2

𝑑𝑌 𝑖′⁄
𝐿′𝑃
= 𝑖′𝑘> 0 since both the denominator and the numerator are positive.
𝑑𝑀 1−𝐶′+
𝐿

This shows that an increase in money supply raises the level of income. The transmission
mechanism in the context of the IS-LM model is that an increase in the money supply lowers the
interest rate, which stimulates investment and thereby expands the demand for goods and services.

[Link]. Interaction between Monetary and Fiscal Policy

Dear learner! When analysing any change in monetary or fiscal policy, it is important to note that
these policies may not be independent of each other. A change in one may influence the other. This
interdependence may alter the impact of a policy change.

Suppose that the fiscal authorities increase taxes. Other things equal, this would reduce output and
interest rate in the short run (Case 1). If the monetary authority is trying to keep interest rates stable,
however, it would respond to this change by decreasing the money supply. The result would be a
larger decrease in output (Case 2). Alternatively, the monetary authorities might be trying to keep
output stable, in which case it would increase the money supply, driving interest rates down further
(Case 3). The basic issue is that the ultimate effects on the economy depend upon the combinations
of policies chosen by the monetary and fiscal authorities.

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Figure .3.22. Fiscal and Monetary policy on IS-LM Model

Dear learner! From Figure 3.22 we can see the response of the economy to a tax increase or how
the economy responds to a tax increase depend on how monetary authority responds.

3.8. Aggregate Demand and the ISLM

Dear learner! We have been using IS-LM model to explain national income in the short run when
the price level is fixed. Now we examine what happens in the IS-LM model if the price level is
allowed to change.

We now consider how the ISLM model can also be viewed as a theory of aggregate demand. We
defined the IS and LM curves in terms of equilibrium in the goods and money markets, respectively.
Aggregate demand summarizes equilibrium in both of these markets.

Recall that the ISLM model is constructed on the basis of a fixed price level. For a given value of
the price level and the nominal money supply, the position of the LM curve is fixed. The real money
supply changes if either the nominal money supply or the price level changes. Thus, we can see that
changes in the price level are associated with changes in the equilibrium level of output and interest
rates. This is the relationship that is summarized by the aggregate demand curve i.e., aggregate
demand describes a relationship between the price level and the level of national income.

If the price level is high, other things equal, the real money supply is low. This implies high interest
rates, and thus low investment and output. If the price level falls, then the real money supply
increases. Equilibrium in the money market implies that interest rates must fall. Equilibrium in the

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goods market thus implies that output must rise, since investment rises. Thus, we find that the
aggregate demand curve is downward sloping; high values of the price level are associated with
low level of output, and vice versa. Notice that the reason this curve slopes downward is not easy
to describe; it is not like the regular microeconomic demand curve for a good.

The aggregate demand curve can also be derived either from equation [3] above or the quantity
theory.
1 𝑖′𝑑𝑚 𝑖′𝑚𝑑𝑃
𝑑𝑌 = 𝑖′𝑘
( − + 𝑑𝐺)
(1 − 𝐶′ + 𝐿 ) 𝐿′𝑃 𝐿′𝑃2

−𝑖′𝑚⁄
𝑑𝑌 𝐿′𝑃 2
= 𝑖′𝑘 < 0; since – i’ > 0 and L’ < 0, and hence the numerator is negative. And the
𝑑𝑃 1−𝐶′+
𝐿

denominator is positive. Thus, dY/dP will be negative.

Alternatively, we can use the quantity theory to derive the above relationship. Consider the quantity
theory
MV = PY
Y= MV/P

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𝑑𝑌 −𝑀𝑉
= <0
𝑑𝑃 𝑃2

Dear learner! How Monetary and Fiscal policy shift the aggregate demand curve? And What
causes the aggregate demand curve to shift? --------------------------------------------------------------
------------------------------------------------------------------------------------. Very good.
Let’s see the reasons together:
Because the aggregate demand curve summarizes the results of the ISLM
Model, shocks that sift the IS curve or the LM curve cause the aggregate demand curve to shift.

➢ 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.
➢ 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.

➢ Conversely, a decrease in 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.

Thus, the result can be summarized as follows:

➢ A change in income in the ISLM model resulting from a change in the price level represents
a movement along the aggregate demand curve.

➢ A change in income in the ISLM model for a fixed price level represents a shift in the
aggregate demand curve.

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The ISLM Model in the short-run and Long Run

The IS-LM model is designed to explain the economy in the short run when the price level is fixed.
Yet, now that we have seen how a change in the price level influences the equilibrium in the IS-
LM model, we can also use the model to describe the economy in the long run when the price level
adjusts to ensure that the economy produces at its natural rate. By using the IS-LM model to
describe the long run, we can show clearly how the Keynesian model of income determination
differs from the classical model.

We can also analyze the transition to the long run in the ISLM model. If the economy is not at full
employment, then the price level adjusts. In terms of the AD-AS diagram, the economy moves
along the AD curve. In terms of the ISLM diagram, the LM curve shifts. Thus, we can see that the
process of adjustment to equilibrium has subtle economic forces lying behind it. If, for example,
we start in recession, then over time prices fall. This increases the real money balance, pushing
down interest rates and encouraging investment. This increase in investment, in turn, leads to higher
spending and higher output.

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Figure.3.25. The short run and long-run equilibrium

In the above figure 3.25.A the three curves that are necessary for understanding the short-run and
long run equilibria: the IS curve, the LM curve, and the vertical line representing the natural rate of
output 𝑌. The LM curve is, as always; drown for a fixed price level, P1. The short-run equilibrium
of the economy is pointing K, where the IS curve crosses the LM curve. Notice that in this short-
run equilibrium, the economy’s income is less than its natural rate.

Figure 3.25.B shows the same situation in the diagram of aggregate supply and aggregate demand.
At the price level P1, the quantity of output demanded is below the natural rate. In other words, at
the existing price level, there is insufficient demand for goods and services to keep the economy
producing at its potential.

In these two diagrams we can examine the short-run equilibrium at which the economy finds itself
and the long-run equilibrium toward which the economy gravitates. Point K describes the short run
equilibrium, because it assumes that the price level is stuck at P1. Eventually, the low demand for
goods and services causes prices to fall, and the economy moves back towards its natural rate. When
the price level reaches P2, the economy is at point C, the long-run equilibrium. The diagram of
aggregate supply and aggregate demand shows that at point C, the quantity of goods and services
demanded equals the natural rate of output. This long-run equilibrium is achieved in the IS-LM

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diagram by a shift in the LM curve: the fall in the price level raises real money balances and
therefore shifts the LM curve to the right.

We can see the key difference between Keynesian and classical approaches to the determination of
national income. The Keynesian assumption (represented by point K) is that the price level is stuck.
Depending on monetary policy, fiscal policy, and the other determinants of aggregate demand,
output may deviate from the natural rate. The classical assumption (represented by point C) is that
the price level is fully flexible. The price level adjusts to ensure that national income is always at
the natural rate.

To make the same point somewhat differently, we can think of the economy as being described by
the equations. The first two are the IS and LM equation:

Y= C (Y-T) + I (r) + G---------------------------IS

M/P= L (r, Y) -------------------------------------LM

The IS equation describes the goods market, and the LM equation describes the money market.
These two equations contain three endogenous variables: Y, P, and r. The Keynesian approach is
to complete the model with the assumption of fixed prices, so the Keynesian third equation is
P=P1
This assumption implies that r and y must adjust to satisfy the IS and LM equations. The classical
approach is to complete the model with the assumption that output reaches the natural rate, so the
classical third equation is

Y= Y
This assumption also implies that r and p must adjust to satisfy the IS and LM equation:

Dear learner! Which assumption do you think is most appropriate?

Well, your answer depends on the time horizon. The classical assumption best describes the long
run. Hence, our long-run analysis of national income and price assumes that output equals the
natural rate. The Keynesian assumption best describe the short run. Therefore, our analysis of
economic fluctuations relies on the assumption of a fixed price level.

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We can also explain the IS-LM in the long run and short-run in the following ways:

In the long run output is equals to its potential level –i.e., Y= Y . Thus, the IS equation will be

IS dY (1-C’) = i’dr + dG, but dY=0 thus

-i’dr = dG---------------------------------- [1]
And the LM equation will be

𝑑𝑚 𝑑𝑝
LM − 𝑚 𝑝2 = Ldr + kdY, but dY = 0. Thus,
𝑝
𝑑𝑚 𝑑𝑝 𝑑𝑚 𝑑𝑝
Ldr = − 𝑚 𝑝2 ➔dr= 𝐿𝑝 − 𝑚 𝐿𝑝2--------- [2]
𝑝

Substituting the [2] into [1] and rearranging to obtain

𝐿𝑃2 𝑖′
𝑑𝑃 =⥂ (𝑑𝐺 + 𝑑𝑚)
𝑖′𝑚 𝐿𝑃
𝑑𝑃 𝑃 𝑑𝑃 𝑑𝑚
=𝑚⇒ = This implies that in the long run, a proportionate change in price is equals to
𝑑𝑚 𝑃 𝑚

the proportional change in the money stock.

The second element of our theory is the money market. The equilibrium in the money market is

M/P = L (i, Y) = L (r, Y)

Where M is the amount of currency supplied to the public by the central bank. Note that, in the
Keynesian theory the price level is fixed so that we can assume that there is no difference between
the nominal and the real interest rate (i.e., r and i are equal). The central bank affects the level of
interest rates by choosing the amount of currency by open market operations the equilibrium in the
money market is determined at the point where the real money supply M/P is equal to the real
money demand L.

We can now express this equilibrium in the money market as a new relation between the real interest
rate r and real output Y, given values of M and P; we will call this relation the LM curve. We derive
this relation in much the same way we did for the IS curve. Start with supply and demand for money
for a given initial value of Y.

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Self-test

Discussion question

1. Explain why the aggregate demand curve slopes down ward

2. What is the impact of an increase in taxes on the interest rate, income, consumption, and
investment?
3. What is the impact of a decrease in the money supply on interest rate, income, consumption,
and investment?
4. Describe the possible effects of falling prices on equilibrium income?

Work out question

1. According to the IS-LM model, what happens to the interest rate, income, consumption and
investment under the following circumstances?
A. The central bank increases the money supply
B. The government increase government purchases
C. The government increase taxes
D. The government increases government purchases and taxes by equal amounts.

2. Given the consumption function C= 200 + 0.75 (Y-T), the investment function I= 200 – 25r.
Government purchases and taxes are both 100.

A. For the above given economy, graph the IS curve for r ranging from 0 to 8.
B. Given the economy demand function (M/P)d = Y – 100r, the money supply M is 1,000
and the price level P is 2. For this economy, graph the LM curve for r ranging from 0
to 8.
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. How much does the IS
curve shift? 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. How much does
the LM curve shift? What are the new equilibrium interest rate and level of income?

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F. With the initial values for monetary and fiscal policy, suppose that the price level rises
from 2 to 4. What happens? What are the new equilibrium interest rate and level of
income?

3. Use the IS-LM diagrams to describe the short-run and long run effects of the following changes
on national income, the interest rate, the price level, consumption, investment, and real money
balances.

A. An increase in the money supply

B. An increase in government purchases
C. An increase in taxes

4. Suppose the government cuts income tax. Show in the IS-LM model the impact of tax cut under
two assumptions:

a) The monetary authority keeps interest rate constant through an accommodating monetary
policy
b) The money stock remains unchanged

5. Assume that the ISLM model of a certain economy is given as:

C = 60 + 0.8Yd M = 100
I = 150 – 10r M (D) = 40 + 0.1Y – 10r
G = 250 P=1
T = 200
a) What is the equation that describes the IS curve?
b) What is the equation that describes the LM curve?
c) What are the equilibrium levels of income and interest?
d) Suppose that governments purchases are raised from 250 to [Link] are the new
equilibrium interest rate and level of income.

e) Suppose that the money supply has increased from 100 to 130. What are the new equilibrium
interest rate and income?

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6. Use the diagram of the Keynesian Cross or Loanable Funds model to show how an increase in
taxes shifts the IS curve.

7. Suppose a wave of credit card fraud causes consumers to use cash more frequently in
transactions. Use the Liquidity Preference model to show how these events shift the LM curve

8. Use the IS-LM model to analyse the effects of the following:

(a) A decrease in taxation is cancelled by an increase in the money supply.
(b) A boom in the stock market that makes consumers wealthier.
(c) After a wave of credit card fraud, consumers use cash more frequently in transactions.

9. Suppose that an economy is described by the following equations:

(a) Explain each of the equations.

(b) Derive the IS curve and briefly explain its meaning.
(c) Derive the LM curve and briefly explain its meaning.
(d) Find the equilibrium levels of Y and R and show that, at this equilibrium position, Md = Ms
holds.
(e) Examine the effects of a doubling in government spending, funded by an equal increase in
taxation.

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Unit Summary

➢ The purpose of this unit is to know about how the aggregate demand curve is derived from the
goods and money market. We now have the tools to analyze the effects of monetary and fiscal
policy in the long run and in the short run. In the long run, prices are flexible, and we use the
classical analysis but in the long-run prices are sticky, and we use the IS-LM model to examine
how changes in policy influence the economy.

➢ The IS-LM model is general theory of the aggregate demand for goods and services. The
exogenous variables in the model are fiscal, monetary policy and the price level. The model
explains two endogenous variables: the interest rate and the level of national income

➢ The IS curve represents the negative relationship between the interest rate and the level of
income that arises from equilibrium in the market for goods and services. The LM curve
represents a positive relationship between the interest rate and the level of income that arises
from equilibrium in the market for real money balances. Equilibrium in the IS-LM model –the
intersection of the IS and LM curves –represents simultaneous equilibrium in the market for
goods and services and in the market for real money balances.

➢ The aggregate demand curve summarizes the results from the IS-LM model by showing
equilibrium income at any given price level. The aggregate demand curve slopes downward
because a lower price level increases real money balance, lowers the interest rate, stimulates
investment spending, and there by raises equilibrium income.

➢ Expansionary fiscal policy-an increase in government purchases or a decrease in taxes-shifts

the IS curve to the right. This shift in the IS curve increases the interest rate and income. The
increase in income represents a right ward shift in the aggregate demand. Similarly,
concretionary fiscal policy shifts the IS curve to the left, lowers the interest rate and income,
and shifts the aggregate demand curve to the left.
➢ Expansionary monetary policy shifts the LM curve downward. This shift in the LM curve
lowers the interest rate and raises income. The increase in income represents a rightward shift
of the aggregate demand curve. Similarly, concretionary monetary policy shifts the LM curve
upward, raises the interest rate, lowers income, and shifts the aggregate demand curve to the
left.
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UNIT FOUR: AGGREGATE SUPPLY ANALYSIS

4.1. Unit Introduction

Dear learner! In the previous unit we examined aggregate demand in some detail. The IS-
LM model shows how changes in monetary and fiscal policy and shocks to the money and goods
market shift the aggregate demand curve. In this unit, we turn our attention to aggregate supply and
develop theories that explain the position and slope of the aggregate supply curve.
Objective of the unit:
By the end of this unit, you are able to know
➢ How aggregate supply curve is derived
➢ Behaviour of aggregate supply in the short run
➢ Behaviour of aggregate supply in long run
➢ Model of aggregate supply: The sticky-wage, sticky-price and imperfect-information.
➢ Aggregate demand and aggregate supply analysis

4.2. Aggregate Supply

Dear learner! You remember that aggregate demand curve shows the negative relationship
between price and output. By itself, the aggregate demand curve does not tell us the price level or
the amount of output; it merely gives a relationship between these two variables. To accompany the
aggregate demand curve, we need another relationship between P and Y that crosses the aggregate
demand curve- an aggregate supply curve.

Definition: Aggregate supply (AS) is the relationship between the quantity of goods and services
supplied and the price level.

The aggregate demand and aggregate supply curves together pin down the economy’s price level
and quantity of output.

Dear learner! Now we need to discuss two different aggregate supply curves this is because the
firms that supply goods and services have flexible prices in the long run but sticky prices in the
short run, the aggregate supply relationship depends on the time horizon.

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Dear learner! do you know the difference between long run and short run periods? --------------
-------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------ That is very good!

Most macroeconomists believe that the key difference between the short run and the long run is the
behavior of prices.
➢ In the long run, prices are flexible and can respond to change in supply or demand.
➢ In the short run, many prices are sticky at some predetermined level. Because prices behave
differently in the short-run than in the long run, economic policies have different effects
over different time horizons.

4.2.1. The long run: The vertical aggregate supply curve

Because the classical model describes how the economy behaves in the long run, we derive the long
run aggregate supply curve from the classical model. To show this, we write
Y= F ( K , L )
=Y
According to the classical model, output does not depend on the price level. To show that output is the
same for all price levels, we draw a vertical aggregate supply curve, in the figure 4.1. The intersection of the
aggregate demand curve with this vertical aggregate supply curve determines the price level.
LRAS, long run aggregate supply
Price
Level=P

Output =Y
0 Y

Figure .4.1. The long run aggregate supply curve

If the aggregate supply is vertical, then changes in aggregate demand affect prices but not output.
For example, if the money supply falls, the aggregate demand curves shift down ward, as in figure
4.2. The economy moves from the old intersection of aggregate supply and aggregate demand, point
A to the new intersection, point B. The shift in aggregate demand affects only prices.
The vertical aggregate supply curve satisfies the classical dichotomy, because it implies that the
level of output is independent of the money supply. This long run level of output, Y , is called the

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full employment or natural level of output. It is the level of output at which the economy’s resources
are fully employed or, more realistically, at which unemployment is at its natural rate.
LRAS
Price

B
AD1

AD2

0 Y Income=output=Y

Figure 4.2 Shifts in Aggregate Demand in the long run

4.2.2. The short run: the Horizontal aggregate supply curve

The classical model and the vertical aggregate supply curve apply only on the long –run. In the
short-run, some prices are sticky and, therefore, do not adjust to changes in demand. Because of
this price stickiness, the short run aggregate supply curve is not vertical.
As an extreme example, suppose that all firms have issued price catalogs and that it costly for them
to issue new ones. Thus, all prices are stuck at predetermined levels. At these prices, firms are
willing to sell as much as their customers are willing to buy, and they hire just enough labour to
produce the amount demanded. Because the price level is fixed, we represent this situation in figure
4.3 below with a horizontal aggregate supply curve.
Price, P

short run aggregate supply, SRAS

0 Income=output=Y

Figure 4.3. The short-run Aggregate supply

The short-run equilibrium of the economy is the intersection of the aggregate demand curve and
this horizontal short-run supply curve. In this case, changes in aggregate demand do affect the level
of output. For example, if the central bank suddenly reduces the money supply, the aggregate
demand curve shifts inward, as in figure 4.4. The economy moves from the old intersection of
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aggregate demand and aggregate supply, point A, to the new intersection, point B. The movement
from point A to point B represents a decline in output at a fixed price level.

Thus, a fall in aggregate demand reduces output in the short-run because prices do not adjust
instantly. After the sudden fall in aggregate demand, firms are stuck with prices that are too high.
With demand low and prices high, firms sell less of their product, so they reduce production and
lay off workers. The economy experiences a recession.

B A SRAS

AD1
AD2

Income=output=Y

Figure .4.4. Shifts in Aggregate Demand in the short-run

4.3. Models of Aggregate supply

Dear learner! We have three models of aggregate supply:
➢ Sticky-wage model
➢ The imperfect-information Model
➢ Sticky-price model
In all the models, some market imperfection (that is, some type of friction) causes the output of the
economy to deviate from the classical target. As a result, the short-run aggregate supply curve is
upward sloping, rather than vertical, and shifts in the aggregate demand curve causes 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 three 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
𝑌 = 𝑌 + 𝛼(𝑃 − 𝑃𝑒 ),  > 0

Pe Where Y is output, Y is the natural rate of output, P is the price level, and is the expected
price level. This equation states that output deviates from its natural rate when the price level

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deviates from the expected price level. The parameter Pe indicates how much output responds to
unexpected changes in the price level; 1/ P e is the slope of the aggregate supply curve.
Each of the three models tells a different story about what lies behind this short-run aggregate
supply equation. In other word, each highlights a particular reason why unexpected movements in
the price level are associated with fluctuation in aggregate output.
4.3.1. The Sticky-Wage Model
Dear learner! 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 the
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:
➢ When the nominal wage is stuck, a rise in the price level lowers the real wage, making
labour cheaper.
➢ The lower real wage induces firms to hire more labour
➢ The additional labour 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 many be the real wage that equilibrate labor supply and demand. More likely, the
target real wage is higher than the equilibrium real wage.

The workers and firms set the nominal wage W based on the target real wage w and on their
expectation of the price level P e . The nominal wage they set is

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W= w  Pe
Nominal wage = Target Real Wage  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

W/P = w  ( P e /P)
Expectedpricelevel
Real wage= Target real wage 
Actuaklpricelevel

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 expected, the real wage is less
than its target; when the actual price level is less than expected, the real wage is greater than its
target.

The final assumption of the sticky-wage model is that employment is determined by the quantity of
labour 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 labour
as the firms wish to buy at the predetermined wage. We describe the firm’s hiring decisions by the
labour demand function

L= Ld (W/P),

This states that the lower the real wage, the more labour firms hire. The labour demand curve is
shown in figure 4.5A. Output is determined by the production function

Y= F (L),

Which states that the more labour is hired, the more output is produced. This is shown in figure
4.5B and figure 4.5C 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 labour hired and output produced. The
aggregate supply curve can be written as
𝑌 = 𝑌 + 𝛼(𝑃 − 𝑃𝑒 )

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Output deviates from its natural level when, the price level deviates from the expected price level.

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4.3.2. The imperfect-Information Model

The second explanation for the upward slope of the short-run aggregate supply curve is called the
imperfect-information model. Unlike the sticky-wage model, this model assumes that markets
clear- that is, all wages and prices are free to adjust to balance supply and demand. In this model,
the short-run and long run aggregate supply curve differs because of temporary misperception 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 earn
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 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 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 framer responds if all prices in the economy, including the price of wheat,
increase:

➢ One possibility is the 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.

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➢ The other possibility is that the framer 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 worked harder and produces more.

Our wheat farmer is not unique. When the price level rises unexpectedly, all suppliers in the
economy observes increase in the price 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:

𝑌 = 𝑌 + 𝛼(𝑃 − 𝑃𝑒 ).

Output deviates from the natural rate when the price level deviates from the expected price level.

4.3.3. Sticky Price Model

The sticky price model emphasizes that firms do not instantly adjust the prices they charge in
response to changes in demand. Sometimes prices are set by long-term contracts between firms and
customers. Even without formal agreements, firms may hold prices stable in order not to aggravate
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 catalogue or price list, it is costly
to alter prices.

To see how sticky prices can help explain an up-ward –sloping aggregate supply curve, we first
consider the pricing decisions of individuals firms and then add to whole. In the previous
discussions we have thought of firms’ choosing how much output to produce, taking as given the
price at which they can sell their output. If we really want to explain why prices may be sticky, we
have to think about who actually sets prices and on what basis. In reality, firms generally set the
prices at which they want to sell their output. To analyze this situation properly, we need models of
imperfect competition in which firms have some monopoly power.

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Consider the pricing decision facing a typical firm. The firm’s desired price p depends on tow
macroeconomic variables:
➢ The overall price 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

p= P + a(Y − Y )
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 Y- Y . The parameter a (a > 0) 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
p= 𝑃𝑒 + 𝑎(𝑌 𝑒 − 𝑌 𝑒 )
For simplicity assume that these firms expect output to be at its natural rate, so the last term,

a(Y e − Y e ) , is zero. Then these firms set price as

p= P e .
That is, firms with sticky prices set their prices based on what they expect others firms to charge.

If s is the fraction of firms with sticky prices and 1 – s the fraction with flexible prices, then the
overall price level is
P = sP e + (1 − s)[ P + a(Y − Y )]
The first term is the price of the sticky-price firms weighted by their fraction in the economy, and
the second term is the price of the flexible-price firms weighted by their fraction. Now subtract (1-
s) P from both sides of this equation to obtain
P − P + sP = sP e + P + a(Y − Y ) − sP − sa(Y − Y ) − P + sP

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sP = sP e + a(Y − Y ) − Sa(Y − Y )

sP = sP e + a(1 − s)[Y − Y ]
Dividing both sides by s to solve for the overall price level:
a(1 − s)
P = Pe + [Y − Y ]
s
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 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.

From the price equation above, we can derive the aggregate supply equation using some algebraic
manipulation.

𝑎(1−𝑠)
Letting to be n, the price equation above can be written as
𝑠

P = P e + n[Y − Y ] , And we can solve for Y- i.e.

𝑛𝑌 = 𝑛𝑌 + 𝑃 − 𝑃𝑒
1
𝑌 = 𝑌 + (𝑃 − 𝑃𝑒 )
𝑛
1
𝐿𝑒𝑡𝑡𝑖𝑛𝑔 𝑡𝑜𝑏𝑒𝑒𝑞𝑢𝑎𝑙𝑠𝑡𝑜𝛼
𝑛
𝑌 = 𝑌 + 𝛼(𝑃 − 𝑃𝑒 )

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.

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4.4. Aggregate demand and aggregate supply in long and short run

P AS2

C
P3=Pe3
AS1
P2 B
P1=P1e=p2e A
AD2
AD1

Y
Y1=Y3= Y

Figure 4.6. Aggregate Demand and Aggregate Supply

In the short run, the equilibrium moves from point A to B. the increase in aggregate demand raises
the actual price level from P1 to P2. Because people did not expect this increase in the price level,
the expected price level remains at Pe2, and output rises from Y1 to Y2, which is above the natural
rate Y . Thus, the unexpected expansion in aggregate demand causes the economy to boom.

Yet the boom does not last forever. In the long run, the expected price level rises to catch up with
reality, causing the SR aggregate supply curve to shift upward. As the expected price level rises
from Pe2 to Pe3, the equilibrium of the economy moves from point B to point C. The actual price
level rises from P2 to P3, and output falls from Y2 to Y3= Y . In other words, the economy returns
to the natural level of output in the long run, but at a much higher price level.

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Self-test
Discussion question

1. Give an example of a price that is sticky in the short run and flexible in the long run
2. Why does the aggregate demand curve slope down ward?
3. Explain the impact of an increase in the money supply in the short run and in the long run
4. Explain the three theories of aggregate supply. On what market imperfection does each theory
rely? What do the theories have in common?

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Unit Summary
➢ The crucial difference between the long run and short run is that prices are flexible in the long
run but sticky in the short run. The model of aggregate supply and aggregate demand provides
a framework to analyze economic fluctuation and see how impact of policies varies over
different time horizons.
➢ In the long run, the aggregate supply curve is vertical because output is determined by the
amounts of capital and labour and by the available technology, but not by the level of prices.
Therefore, shifts in aggregate demand affect the price level but nit output or employment.
➢ In the short run, the aggregate supply curve is horizontal, because wages and prices are sticky
at predetermined levels. Therefore, shifts in aggregate demand affect output and employment.
➢ The three theories of aggregate supply- the sticky-wage, imperfect-information and the sticky-
price models attribute deviations of output and employment from the natural rate to various
market imperfections. Accordingly, to all three 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.
➢ The aggregate demand curve slopes downward. It tells us that the lower the price level, the
greater the aggregate quantity of goods and services demanded.
➢ Shocks to aggregate demand and aggregate supply cause economic fluctuation. Because the
central bank shifts the aggregate demand curve, it can attempt to offset these shocks to maintain
output and employment at their natural rates.

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UNIT FIVE: FOREIGN EXCHANGE - OPEN ECONOMY

5.1. Unit Introduction

Dear learner! In the previous units, we have seen different points with regard to the major
macroeconomic variables. In unit one, we have discussed about the national income or output and
the second unit about the aggregate demand, the third unit about aggregate supply, and unit four
about the two-macro economic variables unemployment and output in closed economy. Now, it is
time to discuss about the open economy macroeconomics.

Do you think that both the monetary and fiscal policies under the open economy remain as effective
as they were under closed economy? Does the kind of exchange rate policy affect the effectiveness
the policy tools? How the degree of mobility of capital does influence the degree of responsiveness
of output to policy instruments? The macroeconomic model will be further extended to include the
foreign sector’s net demand for domestic goods so that both the domestic and external policies will
go beyond the boundary they are intended for. The type of exchange rate system, flexible or fixed,
comes in to play when the policies are practiced in either the domestic or foreign economy. A part
from that the extent of effectiveness of a given policy depends up on the assumption about the
capital mobility across nations.

Moreover, this unit explains how the major components of aggregate demands such as consumption
and investment spending are established on the individual’s behaviour. What factors do affect the
individual’s decision to consume and invest? On what basis can the macro variables be aggregated?
All these issues are going to be discussed in a greater depth in this unit. In addition, the various
kinds of money demand and the instruments used to regulate the money in circulation are those to
be covered here.

Objectives: In this unit, we are going to discuss

➢ Open economy macro-economics
➢ What Foreign Exchange market mean
➢ Types of Foreign Exchange Transaction
➢ Exchange Rate Regimes
➢ Fiscal and Monetary policy on open economy

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5.2. Introduction to Open Economy

Dear learner! The open economy macroeconomics deals with the international transaction that
involves the import and export of merchandises and services. Such a transaction is recorded in the
current account of the balance of payments while the other side of the balance of payments, capital
account, records the transaction of capital flow. Along with the transaction, the kind of exchange
rate put in place also affects the balance of payments. It is now time to complete our macro-
economic analysis by recognizing the linkages among nations.

Any country is linked to the rest of the world through two channels: Trade and Finance

[Link] trade linkage arises from the factor that some of country’s production is exported to foreign
countries, (e.g., coffee export from Ethiopia to Germany) while some good that are consumed
or invested at home are produced abroad and imported (e.g., fuel is imported). It is worthwhile
nothing here how trade linkages affect domestic prices and the demand for our goods.
Dear learners! foreign prices matter in two respects:
A. The price of commodities or raw materials, which are inputs in production, and an element
of producer’s costs are heavily affected by worldwide supply and demand conditions. E.g.,
oil price rise
B. The prices of foreign manufactured goods affect the demand for domestically produced
goods. A decline in the dollar prices of US competitors relative to the prices at which US
firms sell shifts demand away from US goods toward goods produced abroad, and vice
versa.
2. There are also strong international links in the area of finance. US residents, whether households,
Banks, or Corporations can hold US assets such as treasury bills or corporate bonds, or they can
hold Assets in foreign countries, say in Canada.
International investors seeking the best return on their assets link asset markets here and abroad
together, and their actions have fundamental effects on the determination of income, exchange
rates, and the ability of monetary policy to affect interest rates.
Dear learner! Have you heard about Balance of Payment? What does it mean? -------------------
-------------------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------- Excellent!

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➢ The balance of payment is systematic statement of all economic transactions between a

country and the rest of the world.
➢ Because the balance of payments is calculated over the course of a one-year period (Or
one quarter), it is interpreted as a flow concept.
➢ An international transaction refers to the exchange of goods, services, and assets
between residents of one country and those abroad.

But what is meant by the term Resident? Resident includes business, individuals and government
agencies that make the country in question their legal dwelling. Although a corporation is
considered to be a resident of the country in which it is incorporated, its overseas branch or
subsidiary is not. Military personnel, government diplomats, tourists, and workers who emigrate
temporarily are considered residents of the country in which they hold citizenship.

There are two main accounts in the balance of payments:

1. Balance on current account: The totality of merchandise or trade, services, investments
income and unilateral transfers (e.g., remittances, gifts and grants.) The goods and services
component of the current account shows the monetary value of all of the goods and services
a nation exports or imports.
2. Balance on Capital Account: The capital account recorded purchases and sales of assets,
such as stocks, bonds and land. The capital account includes both the private sector and
official (central bank) transactions.

The simple rule for balance of payments accounting is that any transaction that gives rise to
payments by a country’s residents is a deficit item in that country’s balance of payments. Example,
imports of cars, use of foreign shipping, gifts to foreigners, purchases of land abroad or making a
deposit in other countries making international payments. As noted, any transaction that gives rise
to payment by local residents to foreigners is a deficit item. An overall deficit in the balance of
payments- The sum of the current and capital accounts- means, therefore, that the US residents are
making more payments to foreigner than they are receiving from foreigners. Since foreigners want
to be paid in their own currencies, the question of how these payments are to be made arises.

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When the overall balance of payments is in deficit, residents have to pay more foreign currency to
foreigners than is received. The Federal and foreign central banks provide the foreign currency to
make payments to foreigners and the net amount supplies is official reserve transactions.

When the country’s (USA) balance of payments is in surplus, foreigners have to get the dollars with
which to pay for the excess of their payments to the USA over their receipts from sales to USA.

5.3. Foreign Exchange Market

Dear Learner! Can you guess what exchange rate market mean? ------------------------------------
-------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------Very Good!
➢ The foreign exchange market refers to the organizational setting with in which individuals;
business, governments and banks buy and sell foreign currencies and other debt instruments.
Only a small fraction of daily transactions in foreign exchange actually involves trading of
currency; most foreign exchange transactions involve the transfer of bank deposits.
➢ Unlike stock or commodity exchanges, the foreign exchange market is not an organized
structure. It has no centralized meeting place and no formal requirements for participation. Nor
is the foreign exchange market limited to any one country. For any currency, such as the
[Link], the foreign exchange market consists of all locations where dollars are exchanged
for other national currencies.
Three of the largest foreign exchange markets in the world are located in London, New York and
Tokyo. A dozen or so other market centres also exist around the world, such as Paris and Zurich.
Because foreign exchange dealers are in constant telephone and computer contact, the market is
very competitive; in effect, it functions no differently from a centralized market.

A typical foreign exchange market functions at three levels:

1. In transactions between commercial banks and their commercial customers, who are the
ultimate demanders and suppliers of foreign exchange
2. In the domestic inter-bank market conducted through brokers, and
3. In active trading in foreign exchange with banks overseas.

Exporters, importers, investors and tourists buy and sell foreign exchange from and to commercial
banks rather than each other. As an example, consider the import of U.S.A automobile by Ethiopian

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dealer. The dealer is billed for each car it imports at the rate of 50,000 U.S dollar per car. The
Ethiopian dealer cannot write a check for this amount because it does not have a checking account
denominated in U.S dollar. Instead, the dealer goes to the foreign exchange department of, say,
Commercial Bank of Ethiopia to arrange the payment. If the exchange rate is 1$=8 birr, the
automobile dealer writes a check to Commercial Bank of Ethiopia for 400,000 birr (50,000  8) per
car. Commercial Bank of Ethiopia then pay the US manufacturer 50,000 U.S. dollar per car in
U.S.A. Commercial Bank of Ethiopia is able to do this because it has a checking deposit in U.S.
dollar at its branch in U.S.A.

5.3.1. Foreign Exchange Rates

Foreign trade involves the use of different national currencies. The relative price of two currencies
is called the foreign exchange rate, which measures the price of one unit of domestic currency in
terms of foreign currency.

The foreign exchange rate is determined in the foreign exchange markets where different currencies
are traded. The foreign exchange rate is an important determinant of international trade because it
has a large effect on the relative prices of the goods of different countries.

To see how the foreign exchange rate affects foreign trade, take wine as an example. The relative
prices of US wine and French wine will depend up on the foreign exchange rate. Say that California
chardonnay wines sell for $ 6per bottle, while the equivalent French Chardonnay sells for 40 French
Francs. Then, at the 1984 exchange rate of 10 French Frances to the dollar, French wine sells at $4
per bottle while California wine sells at $6, giving an advantage to the imported variety. Say that
by 1996 the foreign exchange rate of the dollar fell (or depreciated) to 5 Frances. Then with
unchanged domestic prices, the French wine would sell $8 as compared to $6 for the California
wine. The fall in the exchange rate on the dollar had the effect of making imports less ‘competitive’
by turning relative prices against imports and in favor of domestic products. If the dollar’s price
had risen, relative prices would have moved in favor of imports and against domestic production.

5.3.2. Types of foreign Exchange Transaction

When conducting purchases and sales of foreign currencies, banks promise to pay a stipulated
amount of currency to another bank or customer on an agreed up-on date. Banks typically engaged
in three types of foreign exchange transaction: Spot, Forward and Swap.

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➢ Spot Transaction: Spot transactions refer to outright purchase and sales of foreign currency
for cash settlement not more than two business days after the date the transactions are recorded
as spot deals. The two-day period, known as immediate delivery, allows time for the two parties
to forward instructions to debit and credit bank accounts at home and abroad.

➢ Forward transaction: In many cases, a business or financial institution knows it will be

receiving or paying an amount of foreign currency on a specific date in the future. Forward
transactions differ from spot transactions in that their maturity date is more than two business
days in the future. A forward exchange contract’s maturity date can be a few months, or even
years, in the future. The exchange rate is fixed when the contract is initially made.

➢ Swaps transaction: Swaps transaction entails the conversion of one currency to another
currency at one point, with an agreement to reconvert it back to the original currency at some
point in the future. The rates of both exchanges are agreed to in advance. Swaps provide an
efficient mechanism through which banks can meet their foreign exchange needs over a period
of time. Banks are able to use a currency for a period in exchange for another currency that is
not needed during that time.

5.3.3. Foreign Exchange Regimes

Dear learner! There are two major exchange rate regimes

1. Flexible Exchange Rate regimes: One basic system occurs when exchange rates move purely
under the influence of market supply and demand. This system, known as flexible exchange
rates, is one where governments neither announce an exchange rate nor take steps to enforce
one. Thus, in a flexible- exchange rate system, the relative prices of currencies are determined
in the market place through the buying and selling of household and businesses.
The flexible exchange rate is also known as floating rate. There are clean and dirty flexible rates:
➢ In a system of clean flexible rates, the exchange rate is determined by supply and demand
without central bank intervention. (Note that intervention is the buying or selling of foreign
exchange by the central bank). What determines the amount of intervention that a central bank
has to do in a fixed exchange rate system? The balance of payments measures the amount of
foreign exchange intervention needed from the central banks. So long as the central bank has

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the necessary reserves, it can continue to intervene in the foreign exchange markets to keep
the exchange market constant.
➢ However, if a country persistently runs deficits in the balance of payments, the central bank
eventually will run out of reserve of foreign exchange and will be unable to continue its
intervention. Before that point is reached, the central bank is likely to decide that it can no
longer maintain the exchange rate, and will devaluate the currency.
Dear learner! Can you guess what devaluation means? ------------------------------------------------
-------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------- Good!
➢ Devaluation means decrease the value of a domestic currency in terms of foreign currency
or
➢ Increase the value of foreign currency in terms of domestic currency.

Country’s use devaluation in order adjusts the balance of payments deficit because devaluation
encourages country’s export while discourage imports. But all countries might not benefit by
devaluing their currency particularly for less developed countries like Ethiopia devaluation fail to
improve the balance of payments deficit this is because:

➢ Even if devaluation encourage export there is a supply rigidity or limitation to cover the increase
in demand of goods or services by foreigners
➢ All most all of the exporting items for less developed countries especially Ethiopia are primary
products but such products are less competitive in the world market. Moreover, the price for
primary products is highly fluctuated.
➢ The summation of import and export elasticity is less than one (  m +  x  1 ) as a result
devaluation does not improve the balance of payments disequilibria for such countries.

2. Fixed Exchange Rate regimes: The other major system is fixed exchange rates, where
governments determine the rate at which their currency will be converted in to other currencies.
In a fixed exchange rate system, foreign central banks stand ready to buy and sell their
currencies at a fixed price in terms of dollars. In a fixed rate system, the central banks have to
finance any balance of payments surplus or deficit that arises at the official exchange rate. They
do that simply by buying or selling all the foreign currency that is not supplied in private

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transaction. Example; if the US were running a deficit in the balance of payments Vis-à-vis
Germany so that the demand for marks in exchange for dollars is greater than the supply of
marks in exchange for dollars, the bank would buy the excess dollars paying for them with
marks.

Fixed exchange rates thus operate like any other price support scheme, such as those in
agricultural markets. Given market demand and supply, the price fixer has to make up the excess
demand or take up the excess supply. In order to be able to ensure that the price (exchange rate)
says fixed, it is obviously necessary to hold an inventory of foreign currencies, or foreign
exchange that can be provided in exchange for the domestic currency.
Dear learner! Do you know what country’s reserve entail? ---------------------------------------
--------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------- excellent!

Foreign central banks held reserves, inventories of dollars and gold that could be sold for
dollars that they would sell in the market when there was an excess demand for dollars and that
they would buy up the dollars when there was an excess supply of dollars.
➢ When the overall balance of payment is in deficit, residents have to pay more foreign
currency to foreigners than is received.
➢ Flexible exchange rate system: the relative prices of currencies are determined in the
market place through the buying and selling of households and business.
➢ Fixed exchange rate system: Governments specify the rate at which their currency will be
converted in to other currencies.

5.4. Fiscal and Monetary policy in open economy

Dear Learner! Here we consider monetary and fiscal policy in an open economy model. There are
several alternatives open economy macroeconomic frameworks. The one used here is the Mundell-
Fleming Model (named after its developer, Robert Mundell and Marcus Fleming) for open
economy macroeconomics.

In an open economy gross domestic product (GDP) differs from that of a closed economy because
there is an additional injection- export expenditure, which represents foreign expenditure on
domestically-, produced goods. There is also an additional leakage; expenditure on imports which
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represents domestic expenditure on foreign goods and which raises foreign national income. The
identity for an open economy is given by:

Y = C + I +G +X – M; Where X –M = net export

You remember our discussion in the previous units about IS-LM Model i.e., the integration of
money, interest and income in to a general equilibrium model of product and money markets.

The IS curve is the locus of those combinations of income and rate of interest at which aggregate
saving equals aggregate investment i.e. saving equals investment, showing that aggregate supply
equals the aggregate demand. Consequently, the IS curve shows the equilibrium of the real sector
of the economy.

The LM curve is the locus of those combinations or pairs of money income and the rate of interest
at which the money market is in equilibrium in the sense that there is equilibrium between the total
demand for and the total supply of money. Each point on the LM curve shows a particular level of
money income and the rate of interest against this income level at which the total demand for money
equals the total supply of money.

5.5. The Mundell-Fleming Model

Dear learner! This model is an open economy version of the IS-LM model considered previously.

The closed economy IS-LM model consists of the following two equations:

M= L (Y, r) -------------------------------- (1) Money Market Equation

S (y) +T = I (r) +G------------------------- (2)  Goods Market Equation

The equation for the IS schedule is derived from the goods market equilibrium condition for a
closed economy:

C+S+T = Y= C +I + G ------------------- (3)

When C is subtracted from both sides

S+ T = I + G-------------------------------- (4)
If we add imports (M) and exports (X) to the model, (3) above is replaced by

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C+S+T  Y=C+I+G+X-M---------------- (5)

And the IS equation becomes
S+T= I+G+X-M--------------------------- (6)
Where (X-M), net exports, is the foreign sector’s contribution to aggregate demand. If we bring
imports over to the left-hand side and indicated the variables up on which each element in the
equation depends.
The open economy IS equation can be written as

S (y) +T +M (y, e) = I (r) +G +X (Yf, e) ------------ (7)

➢ Imports depend positively on income. Import demand also depends negatively on exchange rate
(e). A rise in the exchange rate will make foreign goods more expensive and causes imports to
fall.
➢ Our exports are other countries’ imports and thus depend positively on foreign income (Yf) and
exchange rate. The latter relationship follows because a rise in the exchange rate lowers the cost
of birr measured in terms of the foreign currency and makes Ethiopian goods cheaper for foreign
residents.
Therefore, If r  M
e  M
If Yf X
e X
In constructing the open economy LM-schedule in Fig 5.1 below we hold four variables constant:
the level of taxes and government spending, income, and the exchange rate. Because; these are
variables that shift the curve.

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Interest LM
Rate
BP

IS

0
0 Income

Figure 5.1 Open economy IS-LM Model

Expansionary Shocks: such as an increase in government spending, a cut in taxes, an increase in

foreign income or a rise in the exchange rate, shift the IS curve to the right.

A rise in foreign income is expansionary because it increases demand for our exports. A rise in the
exchange rate (e) is expansionary because it increases exports and reduce import demand for a given
level of income, it shifts demand from foreign to domestic products. An autonomous fall in import
demand is expansionary for the same reason. Changes in the opposite direction in these variables
shifts the IS curve to the left.

In addition to the IS and LM curves, our open economy model will contain a balance of payment
equilibrium curve, the BP curve as we can see in Figure 5.1 above. This curve plots all the interest
rate-income combinations that results in balance of payments equilibrium at a given exchange rate.

Balance of payments equilibrium means that official reserve transaction balance is zero.

The equation for the BP curve can be written as:

X (Yf, e) – M (Y, E) + F(r- rf) = 0--------------------- (8)

Where; X-M= trade balance (net export)

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F= Net capital inflow (the surplus or deficit in the

Capital account in the balance of payments)

The value of F depends positively on the domestic interest rate minus the foreign interest rate (r-rf).
A rise in Ethiopian interest rate relative to the foreign interest rate leads an increase in the demand
for Ethiopian financial assets (e.g., bonds) at the expense of foreign assets; the net capital inflow
increase. A rise in the foreign interest rate has the opposite effect. The foreign interest rate is
assumed to be exogenous.

The BP curve is positively slopped as shown above, as the level of income rises; import demand
increases whereas export demand does not. To maintain balance of payments equilibrium, the
capital inflow must increase, which will happen if the interest rate is higher. Now consider factors
that will shift BP curve:

➢ An increase in e will shift the curve horizontally to the right.

➢ For a given level of the interest rate, which fixes the capital follow, at a higher exchange
rate a higher level of income will be required for balance of payment equilibrium. The
reason is that the higher exchange rate encourages exports and discourages imports; thus, a
higher level of income that will stimulate import demand is needed for balance of payments
equilibrium.
➢ Similarly, an exogenous rise in export demand (due to rise in rf) or fall in import demand
will shift the BP curve to the right.
➢ If exports rise, for example, a given interest rate that again fixes the capital flow, a higher
level of income and therefore of imports is required to restore balance of payments
equilibrium. The BP curve shifts to the right.
➢ A fall in the foreign interest rate would also shift the BP curve to the right; at a given
domestic interest rate (r), the fall in the foreign interest rate increases the capital inflow, for
equilibrium in the balance of payments, imports and therefore income must be higher.

Note that the BP curve will also upward sloping for the case of what is called imperfect capital
mobility.

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➢ For this case, domestic and foreign assets (e.g., bonds) are substitutes, but they are not perfect
ones.
➢ If domestic and foreign assets were perfect substitutes, the case of perfect capital mobility,
investors would move to equalize interest rates among countries.
➢ If one type of asset had a slightly higher interest rate temporarily, investors would switch to that
asset until its rate was driven back down to restore equality.
If assets are less than perfect substitute, then their interest rates need not be equal. Factor that might
make assets in foreign countries less than perfect substitute for Ethiopian assets (for example)
include differential risk on the assets of different countries, risks due to exchange rate changes,
transaction costs, and lack of information on properties of foreign assets.

Self-test
1. Discuss the difference between open and closed Economy
2. What is Foreign Exchange rate market?
3. What is the main difference between the two exchange rate regimes?
4. If a country undertakes devaluation, do you think that will always improve the trade
balance or balance of payment disequilibrium? Explain.
5. If the exchange rate for birr in terms of dollar changes form 1$=8.00 to 1$= 9.00 what
does it mean for birr? And what does it mean for Dollar? Discuss.

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Unit Summery

➢ Net exports are the difference between exports and imports. They are equal to the difference
between what we produced and what we demand for consumption, investment and government
purchase.

➢ The foreign exchange market provides the institutional framework within which individuals;
business, and financial institution purchases and sells foreign exchange.

➢ The exchange rate is the price of one unit of foreign currency in terms of the domestic currency.
From the Ethiopian viewpoint, the exchange rate might refer to the number of birr necessary to
buy a US dollar. Birr depreciation (appreciation) is an increase (decrease) in the number of birr
required to buy a unit of foreign exchange.

➢ The types of foreign exchange transaction include: Forward, Spot and Swamps.

➢ There are two main exchange rate regimes Fixed and Fixable.

➢ The Mundell-Fleming Model is the IS-LM model for a small open economy. It takes the price
level as given and then shows what causes fluctuations in income and the exchange rate.

➢ The Mundell-Fleming Model shows that fiscal policy does not influence aggregate income
under floating exchange (Flexible exchange) rates. A fiscal expansion causes the currency to
appreciate, reducing net exports and offsetting the usual expansionary impact on aggregate
income. Fiscal policy does influence aggregate income under fixed exchange rates.

➢ The Mundell-Fleming Model shows that monetary policy does not influence aggregate income
under fixed exchange rates. Any attempt to expand the money supply is useless, because the
money supply must adjust to ensure that the exchange rate stays as its announced level.
Monetary policy does influence aggregate income under floating exchange rates.

➢ There are advantages to both floating and fixed exchange rates. Floating exchange rates have
monetary policymakers free to pursue objectives other than exchange-rate stability. Fixed
exchange rates reduced some of the uncertainty in international business transaction.

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UNIT SIX: THEORIES OF CONSUMPTION

6.1. Unit introduction

Dear learner! In the previous unit we have seen that the level of national income in an
economy depends up on consumption expenditure, investment and government expenditure. Now
let us introduce you some points about consumption functions and theories of consumption.
Consumption spending as one of the key components in computation of national income which is
mainly governed by the households decision.
Dear learner, this unit deals with issues related to this the consumption spending and/or behaviour
of household sector. Broadly speaking the unit has two main sections. The first section is about
relationship between consumption spending and aggregate demand and how macroeconomics deals
with it. The second section, covers different theories explained consumption behaviour of the
household.
The main objectives of this chapter can be listed out as follow:

➢ Define consumption spending;

➢ Discusses the role of consumption in aggregate demand;
➢ Discuss about the consumption function and their properties
➢ Explain the relationship between consumption and saving;
➢ Identify and explain different theories of consumption; and
➢ Identify factors that determine consumption and spending

6.2. Introduction to Consumption and Saving

What is consumption?
Definition:
➢ The term consumption means the use of a good rather than the expenditure on the good in any
one period.
➢ Consumption expenditure on the other hand is the expenditure on consumer goods in a given
period.
Dear learner! What about saving? ------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------- Good!

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In a simple language, all unconsumed disposable income (Income after tax) is known as Savings.
C= a + cY
The above equation implies consumption is an increasing function of income. Note that a saving
function is directly related to the consumption function. With an increase in the disposable income
of an economy, the personal savings of the recipients of this income and hence the aggregate savings
of the economy also grow.
➢ The proportion of each increment in the level of disposable income that will be saved is the
Marginal Propensity to Save (MPS). That is MPS is the increment to saving per unit increase
in disposable income.
➢ Likewise, the value of the increment to consumer expenditure per unit increment to income is
termed the Marginal Propensity to Consume (MPC).
➢ Thus, the MPS plus the MPC must be one (MPC + MPS = 1)
You should note that the consumer expenditure is the largest component of aggregate demand. This
is why consumption plays a central role in the macroeconomics.
Dear learner! But what factor affect or influence the level of consumer expenditure?
-------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------- Very good!

John Maynard Keynes believes that the level of consumer expenditure was stable function of
disposable income (Yd). Keynes did not deny that variable other than income affect consumption,
but he believed that income was the dominant factor determining consumption. The specific form
of the consumption-income relationship, i.e., the consumption function, proposed by Keynes was
as follows:

C= a + bYd where; a and b are constants Yd is disposable income

As can be seen from the above Keynesian function, when disposable income (Yd) is zero, then the
value of consumption function will be equal to the intercept term a (autonomous consumption).
Thus, as such, a can be thought of as a measure of the effect on consumption of variables other than
income, variables not explicitly included in this simple model (e.g., dissaving, borrowing, etc.). The
parameter b (which is the slope of the function) gives the increase in consumer expenditure per unit
increase in disposable income.

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C
Thus, in notation, b= where; the Greek letter delta  , indicate the change in the variable it
Yd
precedes. Thus, b is the marginal propensity to consume (MPC)

The Keynesian assumption is that consumption will increase with an increase in disposable income
(b  0) but that the increase in consumption will be less than the increase in disposable income(b 
1).
Thus, Keynesians assume that b is between 0 and 1. I.e., 0  b  1 .
From the definition of National income, we know that
Y  C +S +T  Aggregate supply
Yd  Y –T  C +S
This implies that disposable income is, by definition, consumption plus saving. I.e., Yd= C +S
Now we can replace C by a +bYd. Then we can get:
Yd= a +bYd +S
 S= Yd - a – bYd
 S= -a + (1-b) Yd
Note that if a one-unit increase in disposable income leads to an increase of b units in consumption,
then the remainder of the one-unit increase, i.e., (1-b), is the increase in savings:
C
Therefore, = 1- b
Yd
This increment to savings per unit increase in disposable income (1 –b) is the Marginal Propensity
to Save (MPS). Note also that the MPS and the MPC add up to one. This is because the one unit
increment in disposable income is divided in to consumption and savings.

6.3. The Basic Model of Consumer Behaviour

Irving Fisher’s Model based on Micro-foundations Optimising Consumption: A Two-Period Case
Starting from a single consumer with a utility function
U = U (c0,……, ct, ………cT)
Where lifetime utility U is a function of his real consumption c in all time periods up to T, the
instant before he dies. The consumer will try to maximize his utility subject to the constraint that
the present value of his total consumption in life cannot exceed the present value of his total income
in life; that is,

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T T
ct yt
 (1 + r ) =  (1 + r )
0
t
0
t

Where; T is the individual’s expected lifetime. This constraint says that the consumer can allocate
his income stream to a consumption stream by borrowing and lending, but the present value of
consumption is limited by the present value of income. For this restriction to hold as a strict equality,
we assume that if the person receives an inheritance, he passes on a bequest of an equal amount.

6.3.1. An Inter-temporal Model of Consumption

To make the above utility maximization problem analytically tractable, we will take as an example
a particular form of the utility function. Let us assume first that the underlying utility function is
logarithmic, that is,
U(c) = ln c.

This utility function has the usual properties that marginal utility is positive, u’(c) = 1/c, and
diminishing in consumption, u’’(c) = -1/c2 . Second, we will assume that the utility function is
additively separable over time. This means that each period’s marginal utility is independent of the
consumption in all other periods. Third, we assume that future utilities are discounted at the
subjective rate δ. These three assumptions give us the particular specification of utility function of
equation (1) below

𝑙𝑛 𝑐1 𝑙𝑛 𝑐𝑡 𝑙𝑛 𝑐𝑇
[1] 𝑢 = 𝑙𝑛 𝑐0 + +. . . . + +. . . +
1+𝛿 (1+𝛿)𝑡 (1+𝛿)𝑇
𝑇
𝑙𝑛 𝑐𝑡
=∑
(1 + 𝛿)𝑡
0

The constraint on the consumer’s choices in this many-period case comes from total resources
available: current plus all future income. With no bequests, the inter-temporal budget constraint
over the remaining T years of life, in more compact notation, is
T T
ct y
[2] 0 (1 + r ) t = 0 (1 + tr ) t
The consumer faces the problem of maximizing the utility function given by [1], subject to the
constraint given by [2]. This is usually written in the form:
T
ln ct
max  ,
ct
0 (1 +  ) t

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Subject to the constraint that

T T
ct yt
 (1 + r ) =  (1 + r )
0
t
0
t

To solve this problem and obtain the maximizing stream of consumption c0…cT, we will use the
method of Lagrange multipliers. We incorporate the constraint and the objective together into one
expression:
T
ln ct T yt T
ct 
max L =  +    −  t 
0 (1 +  )  0 (1 + r ) 0 (1 + r ) 
ct , t t

The Lagrange multiplier λ is a positive constant that will turn out to measure the marginal utility of
an additional unit of wealth.

The first order conditions of the above expression are given as:
𝜕𝐿 1
[3𝑎] = −𝜆 =0
𝜕𝑐0 𝑐0
𝜕𝐿 1 1 𝜆
[3𝑏] = . − =0
𝜕𝑐𝑡 (1 + 𝛿) 𝑐𝑡 (1 + 𝑟)𝑡
𝑡
𝜕𝐿 1 1 𝜆
[3𝑐] = ∗ − =0
𝜕𝑐𝑇 (1 + 𝛿)𝑇 𝑐𝑇 (1 + 𝑟)𝑇
𝑇 𝑇
𝜕𝐿 𝑦𝑡 𝑐𝑡
[3𝑑] =∑ 𝑡
−∑ =0
𝜕𝜆 (1 + 𝑟) (1 + 𝑟)𝑡
0 0

There will be T marginal conditions like [3a] – [3c], one for each c in (c0,……, ct, ………cT).
Equation [3d] just gives us back the budget constraint.
First, we will compare time 0 consumption c0 to time t consumption, which represents any of the
future periods. If we move the terms in λ to the right-hand sides of [3a] and [3b], we get

ct  1 + r 
t

[4] = 
c0  1 +  
And in general, for any to adjacent periods we would have
ct 1 + r  1+ r 
[5] = , or ct =  ct −1
ct −1 1 +  1+  
These inter-temporal consumption relations have some interesting implications. First from [4] and
[5] we see that whether consumption rises or falls over time depends on whether the market rate of
return is larger or smaller than the individual’s discount rate, that is, whether r >or < δ. From the
technical solutions we see that if r> δ, the consumption path would be rising over time. The market
interest rate r measures the return in additional saving, whereas the discount rate δ gives the
individual’s loss from waiting to consume. If r > δ, it pays to save to consume later; if r< δ, it pays
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to consume more now, less lately. This gives us the time profiles of consumption as shown in the
figure below.
Ct

r>δ

r=δ

r< δ

0 T Time
Figure. 6.1. An Inter-temporal Model of Consumption

A consumption path that begins high because r < δ must cross one that begins low because r > δ.
Their integral must equal the same constraint.

6.3.2. Franco Modigliani and the Life- Cycle Hypothesis

In a series of papers written in the 1950s, Franco Modigliani and his collaborators Albert Ando and
Richard Brumberg used Fisher’s model of consumer behaviour to study the consumption function.
One of their goals was to solve the consumption puzzle- that is, to explain the apparently conflicting
pieces of evidence that came to light when Keynes’s consumption function was brought to the data.
According to Fisher’s model, consumption depends on a person’s lifetime income. Modigliani
emphasized that income varies systematically over people’s lives and that saving allows consumers
to move income from those times in life when income is high to those times when it is low. This
interpretation of consumer behaviour formed the basis of his life-cycle hypothesis.

According to this hypothesis, the typical individual has an income stream that is relatively low at
the beginning and end of a person’s life. This typical income stream is shown as the y curve in the
figure below where T is expected lifetime.

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Figure .6.2. the Life- Cycle Hypothesis

On the other hand, the individual might be expected to maintain a more or less constant, or perhaps
slightly increasing, level of consumption, shown as the c line in the above figure, throughout his
life. This corresponds to the r > δ path in figure 6.1. The constraint on this consumption stream is
that the present value of his total consumption does not exceed the present value of his total income.

Now if the life-cycle hypothesis is correct, if one is to undertake a budget study by selecting a
sample of the population at random and classifying the sample by income level, the high-income
groups will contain a higher-than-average proportion of persons who are at high-income levels
because they are in the middle years of life, and thus have a relatively low c/y ratio. Similarly, the
low-income groups will include relatively more persons whose incomes are low because they are
at the ends of the age distribution, and thus have a high c/y ratio. Thus, if the life cycle theory is
true, a cross-sectional study will show c/y falling as income rises, explaining the cross-sectional
budget studies showing MPC < APC or APC falls with a rise in income.

c0 = k 1 +  (T − 1)y 0L + ka0
C X

kat y L
0

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Over time we may observe a set of points such as those along the line OX, which shows a constant
consumption-income ratio along trend as the economy grows. This constancy of the trend c/y ratio
can be derived from the Ando-Modigliani function as follows.
yL
= k 1 +  (T − 1) t + k t
ct a
yt yt yt

If the c/y ratio given by this equation is constant as income grows along rend, then the line OX, which gives

yL
the APC c/y, will go through the origin. The c/y ratio will be constant if i.e. the labour share in total
y
income and a/y (the ratio of assets, or capital, to output) are roughly constant as the economy grows along
trend.
Thus, the Ando-Modigliani model of consumption behavior explains all three of the observed consumption
phenomena. It explains the MPC < APC result of cross-sectional budget studies by; the life-cycle hypothesis:
it provides an explanation for the cyclical behavior of consumption with the consumption-income ratio
inversely related to income along a short-run function, and it also explains the long-run constancy of the c/y
ratio. In addition, it explicitly includes assets as an explanatory variable in the consumption function.

The Ando-Modigliani model is attractive because it remains close to the original Fisherian
formulation of inter-temporal optimization. It brings out the importance of demographics for trends
in aggregate consumption patterns. For example, with no bequest, no trend in economic growth,
and a static population, the life-cycle hypothesis implies that net aggregate saving is zero. The
dissaving of the young and the old exactly offsets the saving by the middle-aged. If, in contrast, the
population is aging, on average, with many middle-aged high earners now, then the savings rate
will be positive. Likewise in a growing economy, because younger cohorts live during a richer era,
their savings are greater than the dissaving’s from the poorer old folks, and again aggregate savings
are positive. On the other hand, an increase in prospective government retirement (social security)
benefits may reduce gross private sector savings now, matched by an equal reduction in gross
private dissaving’s when current savers retire. Such fairly stable features of societies help explain
why the Japanese save twice as much, in proportional terms, as Americans do.

6.3.3. The Friedman Approach: Permanent Income

In a book published in 1957, Milton Friedman proposed the permanent income hypothesis to
explain consumer behavior. Friedman’s permanent income hypothesis complements Modigliani’s

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life-cycle hypothesis: both use Irving Fisher’s theory of the consumer to argue the consumption
should not depend on current income alone. But unlike the life-cycle hypothesis, which emphasizes
the income follows a regular pattern over a person’s lifetime; the permanent-income hypothesis
emphasizes that people experience random and temporary changes in their incomes from year to
year.

Friedman suggested that we view current income Y as the sum of two components, permanent
income Yp and transitory income YT. That is,

Y =Y P + Y T .
Permanent income is the part of income that people expect to persist into the future. Transitory
income is the part of income that people do not expect to persist. Put differently, permanent income
is average income, and transitory income is the random deviation from that average. Consumption
can also be classified in the same way as income as permanent and transitory- i.e. C = Cp + CT .
Assumptions:

1. Permanent and transitory income are uncorrelated

2. There is no relationship between permanent and transitory consumption.
3. There is no relationship between transitory income and transitory consumption.

The last assumption states that a sudden increase in income, due to transitory fluctuation, will not
contribute immediately to an individual’s consumption. This assumption is intuitively less obvious
than the other ones, but it seems fairly reasonable, because we are dealing with consumption as
opposed to consumer expenditure. Consumption includes, in addition to purchases of nondurable
goods and services, only the “use” of durables- measured by depreciation and interest cost- rather
than expenditure on durables. This means that if a transitory or windfall income is used to purchase
a durable good, this would not appreciably affect current consumption. Thus, Friedman assumes
that the covariance of CT and YT is zero.

Thus, Friedman reasoned that consumption should depend primarily on permanent income, because
consumers use saving and borrowing to smooth consumption response to transitory changes in
income. Friedman concluded that we should view the consumption function as approximately

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C =  Y P , Where α is a constant.
The permanent income hypothesis, as expressed by this equation, states that consumption is
proportional to permanent income. This expression is similar to the life-cycle hypothesis if we view
transitory income as changes in wealth and permanent income as changes in income. The marginal
propensity to consume out of transitory income (wealth) is low; the marginal propensity to consume
out of (permanent) income is high.

The permanent-income hypothesis solves the consumption puzzle by suggesting that the standard
Keynesian consumption function uses the wrong variable. According to the permanent income
hypothesis, consumption depends on permanent income; yet many studies of the consumption
function try to relate consumption to current income. Friedman argued that this errors-in-variables
problem explains the seemingly contradictory findings.

Dividing both sides of the Friedman’s consumption equation by Y to obtain the APC

APC = C/Y = ΑYP/Y.

According to the permanent income hypothesis, the average propensity to consume depends on the
ratio of permanent income to current income. When current income temporarily rises above
permanent income, the APC temporarily falls; when current income temporarily falls below
permanent income, the APC temporarily rises.

Consider the studies of household data. Friedman reasoned that these data reflect a combination of
permanent and transitory income. Households with high permanent income would have
proportionately higher consumption. If all variation in current income came from permanent
component, one would not observe differences in the average propensity to consume across
households. But some of the variation in income comes from the transitory component, and
households with high transitory income would not have higher consumption. Therefore, researchers
would find that high-income households had, on average, lower average propensities to consume.

Similarly consider the studies of time-series data. Friedman reasoned that year-to-year fluctuations
in income are dominated by transitory income. Therefore, years of high income should be years of

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low APC. But over long periods of time- say, from decade to decade- the variation in income comes
from the permanent component. Hence, in long time-series, one should observe a constant APC.

Self-test
1. What is consumption?
2. Discuss how consumption is depend on income and how saving is a function of consumption.
3. How do the life cycle and permanent-income hypothesis resolve the seemingly contradictory
pieces of evidence regarding consumption behaviour?
4. Explain why changes in consumption are unpredictable if consumers obey the permanent-
income hypothesis and have rational expectations.
5. Use Fisher’s model of consumption to analyze an increase in second-period income. Compare
the case in which the consumer faces a binding borrowing constraint and the case in which
he does not.

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Unit Summery

➢ Recent work on consumption builds on Irving Fisher’s Model of the consumer. In this model,
the consumer faces an inter-temporal budget constraint and chooses consumption for the present
and the future to achieve the highest level of lifetime satisfaction. As long as the consumer can
save and borrow consumption depends on the consumer’s lifetime resources.
➢ Modigliani’s Life-Cycle Hypothesis emphasizes that incomes varies somewhat predictably over
a person’s life and that consumers use saving and borrowing to smooth their consumption
depends on both income and wealth.
➢ Friedman’s permanent-income hypothesis emphasizes that individuals experience both
permanent and transitory fluctuations in their income. Because consumers can save and borrow,
and because they want to smooth their consumption, consumption does not respond much to
transitory income. Consumption depends primarily on permanent income.

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UNIT SEVEN: THEORIES OF INVESTMENT

7.1. Unit introduction

Dear learner! Like consumption, investment is also a very important concept. Investment is a
crucial component of any economy because; the growth of the economy depends on the level of
investment. Hence, it is important to understand the concept of investment and its role in the process
of development. In this unit, there are two sections. The first section deals with the meaning and
rationale of investment. In this section, you learn the meaning of investment and criteria used for
investment decisions. The second section deals with the different theories explaining investment.

Objectives:
By the end of this unit, you are expected to:
 explain the meaning of investment and saving;
 explain the relationship between investment and saving;
 explain the motives of investment;
 list and explain the major theories of investment;
 critically differentiate theories of investment; and
 decide on the decision of investment based on criteria.

7.2. The Meaning and Rationales for Investment

Dear learner! The concept and process of investment can be defined from different angles
depending on:

✓ Who invest
✓ The size of resources involved and
✓ The area of investment.
The process of investment is also justified for several reasons. In this section, you will see some of
these concepts of investment and the underlying reasons for investment.

Dear learner! Have you ever thought of the meaning of investment? We will discuss the
same and related issues in this section.

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Investment can be defined as the process of putting one’s resource (money) in a given system with
expectation of some benefits (more income, some products for sale or for consumption and
satisfaction). Some examples of investment process include:

 Establishing a production plant or factory;

 Opening a new business;
 Expanding an existing business or factory;
 Depositing money in saving accounts with intention to collect interest income;
 Constructing public infrastructures such as road, schools and hospitals and
 Building business centres or residential houses and so on.

Investment is considered as an important part of national income accounts. It can be viewed as

either gross investment or net investment. Gross investment represents the total sum of spending
on one or more of the items mentioned above. If we deduct an allowance for the existing structures
and producers’ durable equipment used up in producing the output, we get net investment. For
example, a machine can produce goods and services but at the same time machines wears and tears.
This is known as depreciation, which should be replaced by fresh investments. Therefore, net
investment is given by the gross investment less allowances for such depreciations.

Dear Learners! What are the determinants of investment?

Investment is generally carried out for a variety of reasons. Hence, the determinant of investment
is not a single factor. Some of the major factors that affect investment decision are:

o Market demand (required for investment in production). The larger the market demand the
larger the level of investment would be. The market demand is also positively related to
population size and income level of the population.

o Financial resource. The availability of enough financial resource also has positive implication
for the level of investment.

o Political factors (political stability). Peace and stable political situation encourages investment.

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o Level of uncertainty (level of risk). The higher the level of uncertainty the lower the incentive
for investment will be. Unstable political situation, price fluctuation, fluctuation in the supply of
inputs etc. are some of the sources of uncertainty. Similarly, investing in agricultural production
is one of the areas with higher level of risk.

o Availability and efficiency of banking system (credit or lending institutions). Existence of

efficient banking system or lending institutions facilitates investment process and so affects its
size positively.

o Government economic or investment policy. Conducive investment and related economic

policies encourage investment and increases its level.

o Interest rate (cost of borrowing). Higher interest rate means high cost of borrowing and so
affects investment negatively. This also implies that lower interest rates encourage investment
for two reasons: low cost of borrowing and unattractive interest income to save money instead
of saving.

Besides the aforementioned factors, the size of liquid assets at dispose of the investor, level of
development in research and development, population growth and future consumers demand are
also some of the factors that determine investment level. For instance, the higher the population
growth rate the higher the level of future population and the higher the demand for the public
infrastructures such as schools, public health services, transportation and so on. Such larger
population growth implies also that there will be larger consumer demands. These all have positive
impact on investment. Yet, several macroeconomists emphasize that the market interest rate is the
major determinant of investment level or investment demand.

Dear learners! Did you understand the major determinants of investment? Well done. In the next
section we will learn the motives of investment.

7.3. Purpose/Motive of Investment

Dear learner! Why people invest? What are the motives of investment?

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The first thing that may come to our mind regarding investment is why people and governments
invest. Individuals and governments make investments for various reasons. For example, the
investment a person is making to construct his house is not usually dominated by profit motive.
However, businesspersons investing in a plant to increase production consider the profit they are
going to get over the lifetime of the plant. It is important, therefore, to answer the question why
businesspersons or government makes investments. Let us answer this question before discussing
other issues related to investment.

We can divide the reasons why agents invest in to two major motives:
 Profit motive and;
 Non-profit motive
Hence, the answer to this question is based on the rationale and justification for investment
activities. The purpose of investment is either a profit motive or non-profit motives. Most of the
private investors have profit motive whereas government and non-governmental organizations may
involve in investment projects because of non-profit motives such as welfare and national growth
issues.
A. Profit Motives

People or individuals like to invest their money on new plants and equipment because they believe
that this helps them to make profit. As investment in capital goods remains for many years before
it brings profit, one can learn only after several years whether the investment is profitable or not.
The return to investment in plant and equipment is spread over a number of years. For example, a
manager who has invested in a machine to increase output can expect profits from a particular plant
over a 10 years period.
Once we have this kind of situation, the decision to invest becomes complicated because profits
received today are worth more than the profits received in the future. This is so because the profits
received today can be loaned at the market rate of interest and more interest income can be
generated from it. Therefore, in making investment decisions managers cannot just add profits
received for the various years and compare total profits with the cost of investment. The decision
to investment is hence a little complicated and to know if the investment is profitable or not and to
rank investment projects in the order of overall profitability, individual investors and governments

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use different investment decision criteria such as present value criterion and marginal efficiency
criterion. These criteria compare whether investment project is profitable or not.
Investment Criteria: The Decision to Invest
The decision to invest on plant and equipment involves the same sort of analysis. The prospective
investor must calculate the present value of the income stream associated with the investment
project and compare with the cost of the project. If the cost of project is less than the present value
of the future income then it is profitable for the investor to invest. In real life, of course, the process
is more difficult because of uncertainty associated with the project. To conclude, we can say that
the decision to invest depends on three related elements. These are:
• The expected income flow from the capital good in question;
• The purchase price of that good (cost of the investment project); and
• The market rate of the return from the project or sale of the products, which in turn depends
on the market demand for the product.

These are usually the major elements that individual investors consider in making decision, whether
to make investment expenditure or not given that other factors at national level (market demand;
financial resource; political factors or political stability, level of uncertainty or risk, availability and
efficiency of banking system, government economic or investment policy and so on mentioned
earlier are constant or are met.

Example: Given the present value of stream of returns and the required amount of money for the
investment by different parties (A, B, C, D and E) as follows, decide whether each party has to
make the investment or not if we consider the profit motive of investment.

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Table 7.1. Decision of investment

Present value of the The amount of money
Decision whether to
Investing estimated returns from the required for the investment
invest or not.
parties investment (in Birr) (in Birr)
A 8,000 10,000 A
B 80,000 70,000 B
C 6,000 6,000 C
D 45,000 40,000 D
E 70,000 100,000 E

Solution
a. For the first party ‘A’, since the present value of the return from the investment is less than the
amount of money required, which is the cost of the investment (8,000 < 10,000), it is proper not
to invest.
b. With similar argument for party ‘B’ since the present value of the benefit or the return is larger
than the cost (80,000 > 70,000), it is preferable to invest the resource or the money.
c. For party ‘C’, since both the present value of the return and the cost are equal (6,000 = 6,000),
it is the same for the party to invest or not. From the point of view of producers, it may be
advisable to invest with the argument that the party will accumulate experience; however, from
the point of view of national economy it is better not to invest and rather to save the money to
provide the fund for some other alternative investments.
d. For party ‘D’, since the present value of the return is greater than the cost (45,000 > 40,000) it
is better to invest the money.
e. For part ‘C’, the present value of the benefit of the investment is highly smaller than the cost
for the investment (70,000 < 100,000). Therefore, it is better not to invest; rather it is better to
save the money to provide fund for other investment activities.

Present Value (PV) Criterion

Dear learner! To understand this criterion let us take an example.

Suppose an individual is to receive 1,100 Birr after one year form today. If the market rate of interest
is 10 percent, what is the value of 1,100 Birr today? In other words, what is the present value of
1,100 Birr payable after a year given market rate of interest to 10 percent? If you are not clear about

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the example then let us make it even simpler. What amount should be lent today at market interest
rate, which is 10 percent in our example, to get birr 1,100 after one year?

Let us solve the question. Let ‘X’ be the amount of money lent at 10% for one year to get 1,100
birr by the end of the year. Now let us find the value of X.
X money is lent for one year at 10 percent means after one year 10% of ‘X’ interest will be added
on X to give us 1,100.
X + X (10%) = 1,100
10 X
X+ = 1,100
100
100 X + 10 X
 = 1100
100
 110 X = (1100)(100)
so X = 1000

In this case, we see that the present value (today’s value) of 1,100 Birr is only 1,000 birr at 10%
rate of interest. In the present value criterion, the present values of future returns of different
investment alternative are first calculated and compared for decision. These values actually depend
on the level of interest rates that are maintained by the central banks government policy. Using the
method given in the above example, we can develop the general formula to calculate the present
value of the future income streams. If an individual has an initial amount P0 which he/she lends at
market rate of interest ‘i’, then he/she will have P1 at the end of one year. Now again he/she lends
his initial amount of P1 at ‘i’ he/she will get P2 amount at the end of two years and so on.
Mathematically, this can be represented as follows:

First year  P1 = P0 + iP0 = P0 (1 + i)1 ......................................(1)

Second year  P2 = P1 + iP1 = P1 (1 + i )1 ...................................(2)

Since P1= P0 (1+ i), by substituting equation (1) in equation (2) we get the following result:
P2 = P0 (1 + i )(1 + i )
P2 = P0 (1 + i ) 2 ........................................................................(3)

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Similarly, the person again invests for another year at the market rate of interest, and then he/she
would have P0 (1 + i ) 3 at the end of the third year. Following this, we can have a general formula

which can be written as:

Pn = P0 (1 + i) n ...........................................................................(4)

Where Pnis the amount one gets at the end of ‘n’ years at market rate of interest (i) if one invests P0
amount today or this year. The present value of income to be received after ‘n’ years equals the
amount an individual would have to lend at the market rate of interest ‘i’ for ‘n’ years in order to
receive the given amount Pn. The present value given by ‘Po’ is obtained by solving for ‘Po’ from
equation (4) above. The general formula for the present value of future income is given as follows:
Pn
P0 = ............................................................................(5)
(1 + i) n
In investment decision making process, projects with larger present values are preferred to be
invested in. The above equation shows that the present value and market rate of interest are
inversely related. If the market rate of interest increases, the present value decreases. This means
that higher interest rates lead to lower investment and so lower national output or gross domestic
product (GDP). This is because of two major facts:

1) Higher interest rate makes people interested more in saving than to invest as they receive
larger interest income.

2) As interest rate gets larger and larger, the cost of borrowing will be higher and makes
investment through borrowing expensive.

Thus, central banks and the government have to maintain moderately lower interest rates to have
healthy investment environment.

In investment projects, the streams of future incomes in different times can be taken as sum of these
discounted values at the end of every year we pass through for the life of the investment project.
For simplicity, we discount every year and add the present value of each income received in future.
After discounting every year, we can obtain the general formula of present value (PV). Which is:
P1 P2 P3 Pn
PV = + + + ......+ ...................................(6)
(1 + i) (1 + i) (1 + i)
1 2 3
(1 + i) n

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Marginal Efficiency Criterion

Marginal efficiency criteria is about comparing a discount rate that discounts the total stream of
future returns to the value equal to cost of the current investment with the market interest rate. In
other words, marginal efficiency of capital (r) is the rate of interest, which equates the cost of the
project and the discounted value of the future income stream associated with the project. Then, the
discount rate (r) will be compared with the market or banks interest rate (i), which is the cost of
borrowing or the return on saving. If the discount rate (r) is greater than the market or banks interest
rate (i), it means that the money put into the investment is increasing itself by larger rate through
returns from the investment products than it brings if we save in banks or than the rate we should
pay if we borrow the money for the investment.

The implication of this criterion is that lower market or banks interest rate (i) encourages
investment. It also implies that the government or the central banks have to maintain reasonably
low interest rates using different instruments such as money supply regulation to have better
investment condition. As it is part of investment theories, this concept will be more elaborated in
the next section.
B. Non-Profit Motives

People, non-governmental organizations and governments participate in investment practices for

non-profit motives. The most important non-profit motive is the welfare reason or humanitarian
issues. Individuals and non-governmental organizations spend their resources on investment to
benefit a community from the return from the investments. There is national or political obligation
on the government of a country to spend on some investment activities in providing the society with
some basic infrastructure such as road, schools and health infrastructures. These usually account
for a considerable proportion of government expenditure (G) in national income identity or gross
domestic product (GDP) given by:

GDP = C + I + G + X – M or Y =C+I+G+X–M or
GDP = C + I + G + NX or
Where Y = national income
GDP = Gross Domestic Product
C = private sector consumption spending
I = private sector investment spending or investment demand

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G = government sector spending

NX = X – M = Net export
X = Export value
M = Expenditure on import
For more on national income identity please study the national income accounting.

Crowding Out Effect

Dear learner! Did you know that increase in government investment has negative impact on
private investment? Don’t worry. In the following explanation we are going to learn crowding out
effect of government investment.

Once we discussed the investment made by the government for non-profit motives, it is also
important to see the negative effect of this government investment activity on the overall level of
investment called crowding out effect. Crowding effect represents the case where the government
action such as fiscal policy or government investment activity itself reduces the investment in the
private sector. For instance, an increase in government expenditure on investment or some other
activities reduces the government saving. This increases interest rate and as a result, investment
declines as borrowing become expensive.

Figure 7.1: Crowding Out Effect increase in government spending

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Figure 7.1 indicates that the government investment expenditure has a crowding out effect, it
reduces private investment. When the government investment increases, the government either cut
its saving (shifting saving curve from S1 to S1) as money moves to the investment or the government
increases borrowing. Both borrowing and reduction in saving pushes the interest upward (from r1
tor2) making the borrowing expensive for private investors. Therefore, private investors cut their
investment spending from I1 to I2. This is also contributed to by increased private saving attracted
by higher interest income.

Self-test

1. Define investment.
2. List and explain the major determinants of investment.
3. What are the major motives of investment?
4. List and explain the major criteria of investment.
5. Briefly explain the crowding out effect.
6. Explain the role of investment on the growth of one country.

7.4. Theories of Investment

Dear learner! We have learnt the basic concept of investment and the decision criteria in the
previous section. We have also introduced some of the factors that determine investment. However,
the discussion of the relationship between investment and its determinants has been too shallow
that we shall see the same in more detail. To help this, there are several theories which try to explain
the relationship between investment and its determinant factors. In this section, we will discuss
some of these investment theories.

7.4.1. Keynesian Marginal Efficiency of Capital

Keynesian marginal efficiency of capital (MEC) is an alternative theory or approach in making
investment decision under profit-oriented investment motive. In this approach, the comparison is
between marginal efficiency of capital (r) and market rate of interest (i). Marginal efficiency of
capital (r) is the rate of interest, which equates the cost of the project and the discounted value of
the future income stream associated with the project. To calculate the marginal efficiency of capital
(r), we obtain the estimates of the cost of the project (C) and the future income stream associated

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with the projects, P1, P2… Pn. Where the subscripts: 1, 2, 3………………. n. represents the years
(from now) in which the returns are received. These values are substituted into the general formula
of discounting process.

𝑃1 𝑃2 𝑃3 𝑃𝑛
𝐶= + + + ...... + ......................(7)
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)𝑛

In equation (7), we must solve for the unknown ‘r’. Then the investor must compare it with the
market rate of interest (i). If the marginal efficiency of investment (r) is less than the market rate of
interest, the project is not profitable. The investor can be better off by simply lending or saving at
market rate of interest rather than investing. This is because the lower value of marginal efficiency
of investment (r) measures the rate of return on the money used in the investment.

If the marginal efficiency of investment (r) is greater than the market rate of interest (i), the project
is profitable. This means that the return on the money used for investment given by the marginal
efficiency of investment (r) is larger if we put or use the money for the investment than the return
on it if we save or lend at market interest rate (i). From the point of view of profit oriented private
or government investment, it is suggested by this theory that investment resource or money is better
used for investment activity than to save or to lend at market interest rate if the marginal efficiency
of investment (r) is greater than the market interest rate. This implies that the capital or the money
will be more efficient at margin if it is invested than if it is saved or lent at market or banks interest
rate. This suggestion can be summarized as follows:

Table 7.2. Decision of investment

If Investing is Preferred use of the capital or money
r>i More profitable For investment
r<i Less profitable To save/lend or to use in alternative investment activity.

In the investment decision-making process, the market rate of interest plays a crucial role. If the
rate of interest is very high, then it may make investment projects very expensive and unprofitable.
This is because the marginal efficiency of capital is less than the cost of the investment which is the
market interest rate. If market rate is low then it may make some previously unprofitable projects
as profitable because this is equivalent to lowering the cost of investment.

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From the discussions so far it easy to conclude that almost all investment theories directly or
indirectly explain or state that it is the banks or market interest rates that determine investment.
These theories indirectly emphasize the role of the government or the central bank (the national
bank) of a country to maintain the level of interest rate to have the appropriate level of investment
demand or investment spending in the country. This means that the national bank should be able to
maintain the appropriate level of market interest rate.

7.4.2. Present Value criterion Vs Marginal Efficiency of Capital

Before going to the discussion of other investment theories and to the discussion of a more
aggregate and general relationship between investment demand and interest rates, let us make a
comparison between the two more micro-level investment theories we have discussed above:
Present Value criterion (PV) Vs Marginal Efficiency of capital (MEC). Take two investment
projects both with total cost C = 1 billion Birr whose income streams or returns will be collected in
two years.

The present value (PV) ranking depends on the market rate of interest (i) (the rate at which earnings
can be reinvested or saved to collect interest income on it), while marginal efficiency (r) is not
related to market rate. Thus, the present value (PV) ranking can be different from marginal
efficiency (r) ranking.

Table 7.3. Decision of investment

Return in period-1 (after one year) Return in period-2 (after two years) (In
(In billions Birr) billions Birr)
Project I 0 4
Project II 2 1

a) Marginal Efficiency (r) Criteria.

i. For Project-I
P1 P2
C= +
(1 + r ) (1 + r ) 2
1

0 4
1= + ……………………………….. (8)
(1 + r ) 1
(1 + r ) 2

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We need to find the value of ‘r’. Solving for ‘r’ from the equation (9), we get the following:
4
1 = 0 +
(1 + r ) 2

4
1 =
(1 + r ) 2

 (1 + r ) 2 = 4
 (1 + r ) = 2
 r =1
The marginal efficiency of project-I is equal to one, (r = 1)
Similarly, repeating the same calculation for project II, we obtain the following:

ii. For Project-II

P1 P2
C= +
(1 + r ) (1 + r ) 2
1

2 1
1= + …………………………………. (10)
(1 + r ) 1
(1 + r ) 2

We need to find the value of ‘r’. Solving for ‘r’ from equation (10), we get the following:
2 1
1= +
(1 + r ) 1
(1 + r ) 2

2(1 + r ) + 1
1=
(1 + r ) 2
 (1 + r ) 2 = 2 + 2r + 1
 1 + r 2 + 2r = 3 + 2r
 1 + r 2 + 2r − 2r − 3 = 0
 r2 − 2 = 0
 r2 = 2
 r = 1.414
Thus, the marginal efficiency of capital for the second project is: (r = 1.414).

From the above results of the two projects, the marginal efficiency criteria suggest us that project-
II is better than project-I because of its higher marginal efficiency value. This means that the stream

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of return for project II shows that it has higher rate of return. But the present value (PV) criteria
don’t have such answer for investment ranking because it depends on market rate of interest (i).

We can consider the impact of change in interest rate on the level of investment in a given project
or capital good. A single investment spending is made at the point where marginal efficiency of the
capital (MEC) equals marginal cost of the capital good measured in terms of interest rate. This point
is defined at the point of intersection of marginal efficiency curve and interest rate curve given by
Figure 7.2.

As one can see, the figure describes the fact that as the size of total investment increases; we
(investors) go to projects with lower and lower return streams. Thus, as investment raises the
marginal efficiency of capital (m) falls showing an inverse relationship between the marginal
efficiency of capital and investment level.

When there is a rise in profit (may be through higher retained earnings) which means less demand
for loan, the horizontal part of the interest rate curve is extended and the equilibrium investment
level goes from I0 to I1(i.e., from ‘a’ to ‘b’). The horizontal part represents financing project from
own retained earnings (not from loan and so it is not the function of interest. rate). As the demand
for loan declines because of higher profit or retained earnings, the interest rate ‘r’ declines and
investment rise (saving declines). As interest rate declines (r0 to r1), investment increases from I0
to I1 as shown in Figure 7.2 given by the movement from point ‘a’ to point ‘b’

Figure 7.2: Investment, Marginal efficiency of capital (MEC) and interest rate

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All internal finances such as depreciation and retained earnings are associated with low interest rate
representing the flat part of the cure. But external finances such as loan are associated with higher
interest rate and are represented by the rising portion of the curve.

b) Present Value (PV) Criteria.

i. If market rate of interest (i) = 0
Project-I
0 4
PV1 = + =4
(1 + 0 )
1
(1 + 0 )2
Project-II
2 1
PV2 = + =3
(1 + 0) (1 + 0 )2
1

Assuming cost of the project in both the cases is equal to one, project-I is superior to project-II.
This is because present value criteria suggest that the return on project-I is equivalent to 4 billion
Birr of today or current year whereas the value for the second project is only 3 billion Birr.

ii. If market rate of interest (i) = 1

Project-I
0 4
PV1 = + =1
(1 + 1) (1 + 1)2
1

PV1 = 1 billion Birr

Project-II
2 1
PV2 = + = 1.25
(1 + 1) (1 + 1)2
1

PV2 = 1.25 billion Birr

Assuming cost of the projects in both the cases is equal to one billion Birr, when the market rate of
interest is equal to one (r = 1), project-II is superior to project-I. Therefore, there must be a rate
between 0 and 1 for which the present value of the two projects are equal. This rate can be obtained
by equating the present value functions of both projects.
PV1 = PV2
0 4 2 1
+ = + …………………………. (11)
(1 + r ) (1 + r ) (1 + r ) (1 + r )2
1 2 1

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Solving for ‘r’ from this identity, we obtain the following:

4 2(1 + r ) + 1
=
(1 + r )2
(1 + r )2
4 = 2 + 2r + 1
2r = 1 r = 1/2
r = 0.5
At r = 0.5 both projects have the same ranking. This condition of the projects can be graphically
represented as follows.

Figure 7.3: Present Values (PV) of different investment projects

7.5. Investment Demand and Interest Rate

Dear learner! What is the relationship between investment and interest rate?

Investments demand (I) has negative relationship with market or banks interest rate (r). That means
the higher the interest rate, the lower the investment level will be. There are two major reasons for
this negative or inverse relationship between investment demand (I) and interest rate (r).
a) Higher interest rate makes owners of capital (financial resource) prefer to save their money in
banks to receive the higher interest income than to invest in capital goods and so imply lower
investment level.

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b) Higher interest rate also makes investment fund or borrowing expensive. Investors who want to
invest by borrowing have to pay higher interest rate on the loan. Paying higher interest rate on
the loan again reduces the profit of the investor and the interest to borrow and invest.
This reality can be shown by down ward sloping investment demand curve. From the following
Figure 18, one can see that the level of investment is equal to I1 when the market interest rate is
equal to r1. However, when the interest rate increases to r2 the investment level declines to I2 owing
to the two major reasons mentioned above. Most of the investment theories are intrinsic to this
relationship between investment and interest rate. It is the level of interest rate that determines or
affects the level of investment symbolized by the relation: I = f(r).

Figure 7.4. Investment demand curve

Being the important determinant of investment, interest rate by itself is affected by several factors.
Some of these factors are:

a. Level of saving known as supply of loanable fund. High saving increases the supply for loan
and make loan cheaper by reducing interest rate.
b. Level of income of the people, which determine the ability to save.
c. The demand for investment itself has effect on interest rate. Higher investment demand pushes
the interest rate up and make loan expensive.
d. The level of money supply is another factor that affects interest rate and so investment level.
Higher money supply makes loan cheaper and pushes the interest rate down.

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e. Government may borrow from banks for the use of public sector investment spending. Higher
government expenditure also pushes the interest rate upward and reduces investment in the
private sector known as crowding out effect.

Dear learner! It is possible to show the relationship between investment and interest rate, using
graph, table, and mathematics. The following table shows how we can show the relationship
between investment and interest rate by using table.

Example: Given two levels of interest rates and corresponding levels of investment demands,
estimate the investment function if it is a linear function.

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Table 7.4. Investment and interest rate relationships

Level of interest rate (r) in % Investment level (I) (in million Birr)
5 (or = 5%) 100
10 (or =10%) 50

Solution:
Using the points: (r, I), (5, 100) and (10, 50)
The slope of the function remains constant at different points of the curve. Thus:

 r − 5   5 − 10   −5
The slope =  = =   = - 0.1
 I − 100   100 − 50   50 

 r −5 
  = −0.1
 I − 100 
 (r − 5) = −0.1( I − 100)
 (r − 5) = −0.1I + 10
 0.1I = −r + 15
 I = −10r + 150

Such investment function is used for estimation or forecasting investment demand and in
controlling interest rate at the level or levels that would bring the appropriate level of investment.
For instance, in the above investment function, to keep the investment level at 100 million Birr, the
interest rate should be set at 5% i.e. (r = 5). This can be calculating as follows:

 I = −10r + 150
 100 = −10r + 150
 10r = −100 + 150
 10r = 50
r =5
 r = 5%

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7.6. Investment and saving, and their relationship

Dear learner! What is the meaning of saving? What are the major advantages of saving? What
is the relationship between investment and saving? Well done. In the following section we are going
to learn them in detail.

Investment spending is on the demand side where as saving is on the supply side of investment and
finance sectors. The level of saving is one of the major determinants of the level of investment.
That is investment is determined by the level of supply of the investment resources, which is saving.
This is because the level of saving determines the level of interest rate, which is the cost of
borrowing or the opportunity cost of investment. The higher the saving, the lower the interest rate
will be and the more the investment expenditure will be since the cost of borrowing or opportunity
cost of investing their money (foregone interest income) will be lower. Saving is known as supply
of loanable fund whereas the interest rate is known as the price of the loan. Thus, the larger the
supply of the fund, the lower its price will be and so the higher the demand for investment will be.

On the other hand, the level of interest rate affects saving and investment in opposite direction.
Higher interest rate discourages investment since cost of borrowing/ opportunity cost of investment
is high. However, higher interest rate encourages more saving since helps people to receive larger
interest income. This means investment is a negative function interest rate whereas saving is a
positive function of interest rate. Thus, saving curve is upward sloping as opposed to investment
function. In a two-sector model, where there is no government sector, and with assumption of
banks’ efficient transfer of saving to investment through loan, the value of investment is equal to
the value of saving. Such condition is also referred to as equilibrium condition.

The Figure 7.5 depicts that the equilibrium level of investment and saving is equal to I*; (I = S)
defined at the point of intersection between the saving and the investment curves. In market type or
free market economy, excess saving beyond the intersection point pushes the interest rate down and
limited saving pushes the interest rates up. In most countries or economies where there is no
efficient market operation or where there is no enough saving and investment capacity to regulate
interest rate, the government or the central bank (the national bank) has to control the level of
interest rate.

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Moreover, the largest proportion of saving or supply for loanable fund comes from the government
saving. Thus, during a fiscal year with relatively high government expenditure, the saving will be
relatively low. This would push the interest rate up and make borrowing expensive or opportunity
cost of investment will be higher and investment will be lower. As a result, by several economists
and governments have been recommending households to save as larger proportion of their income
as possible to encourage investment.

Figure 7.5. Investment demand and saving curves

However, the above saving-investment relationship regulated or determined through their relation
to the interest rate and households’ savings may not hold true all the time for all types of economy.
There may be some exceptions under some extreme cases. To discuss this condition let us try to
answer the following question.
The Paradox of Thrift/Saving
There is a level of saving in a country, which leads to the malfunctioning of investment sector of
an economy. This level of saving at least creates a negative influence on the investment activities.
This is the situation where the larger proportions of households save the larger proportion of their
income would be. Households are saving the larger proportion of their income means they are
consuming the smaller proportion of their income. This is because the household’s disposable
income is either saved or consumed given by the following relation:
Yd = C + S
The larger the saving the smaller the consumption will be. Lower consumption level again implies
lower demand for the products of different investment activities and other national products. This

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discourages further investment and reduces aggregate demand and national output or national
income. This can easily be seen in the following national income identity:
Y  GDP = C + I + G + X – M
Excessive saving reduces the value of ‘C’ and this discourages investment leading to smaller value
of ‘I’. Both of these impacts of excessive saving by households finally lead to lower-level national
income.

Y   GDP  = C  + I  + G + X – M

This is what is known as the paradox of thrift or the paradox of saving where it affects the
national income negatively even if it is expected to improve national income by encouraging
investment.

Self-test

1. What is the difference between marginal efficiency criteria and present value criteria?
2. Explain the paradox of saving
3. What are the major determinants of interest rate?
4. Use the graph and explanation to show the relationship between interest rate and investment.

7.7. Other Theories of Investment

Dear Learner! Before winding up this section, now let us see some other major investment theories
that explain special situation leading to different level or types of relations among the investment
and/or saving and the factors affecting them.

As we have seen, investment is sensitive to interest rate; Keynesians and Classical economists also
believed the same. Starting in the late 1930s, economists became increasingly skeptical about the
importance of interest rate as a determinant of investment. Empirical studies during that time (in
1930s) indicated that investment is relatively insensitive to interest rates. As a result, many
alternative theories were developed. Next, we will discuss three of these theories of investment,
which are:
a. Accelerator theory of investment;
b. Internal fund theory of investment;

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c. Tobin q – theory of investment;

d. Neo-classical theory of investment; and
e. Inventory investment

7.7.1. Accelerator Theory of Investment

The relationship between the change in the level of output and the volume of investment is known
as acceleration principle. This is because, addition to the capital good through the investment is
intended to accelerate or add to the output of the existing one. The capital-output ratio is known as
accelerator. This theory assumes that a particular amount of capital stock is necessary to produce a
given amount of output. For example, if a capital stock of 500 birr is needed to produce 100 birr of
output and if this keeps true over periods and different level of capital, then we can say that there
is a fixed relationship between the capital stock and output. Let us assume that the ratio is given by
a constant ‘  ’, we can explain the relation with the following equations:
Kt
=
Yt
 K t = Yt .......................................(13)
Where  is the ratio of capital (Kt) in time period ‘t’ to the output ‘Y’ in time period ‘t’. If  is
constant, the same relationship is true for the previous year hence we can write the same relationship
as follows:
K t −1 = Yt −1 .....................................(14 )

By subtracting equation (14) from equation (13) we get:

K t − K t −1 =  (Yt − Yt −1 ) ..............................(15)

The expression Kt- Kt-1 is the difference between the capital stock in time period ‘t’ and the capital
stock in time period ‘t-1’ is known as net investment. Net investment is equal to the capital output
ratio multiplied by the difference in the output in the two time periods. By definition net investment
is equal to the gross investment (I) minus capital consumption allowance or depreciation (D). This
can be incorporated in our equation as follows:
I t − D =  (Yt − Yt −1 ) = Y .................................(16)

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Equation (16) gives the expression that net investment equals the accelerator coefficient (  )
multiplied by the change in output. In other words, investment is a function of output. If output
increases, the net investment also increases.

If in an economy a capital stock of 500 birr is needed to produce 100 birr of output, then the value
of  is 5. If aggregate demand is 100 birr worth of output, then investment should be 500 birr. This
means that if aggregate demand is constant then net investment is zero. Because net investment is
given as follows:

I t − D =  (Yt − Yt −1 ) = Y

However, the aggregate demand is constant means Yt and Yt-1 are equal and Yt - Yt-1 = 0.
I t − D =  (Yt − Yt −1 ) = Y =  (0)

It − D = 0
Net investment = 0
Suppose aggregate demand increases from 100 to 105 Birr worth of output, and then the investment
need is equal to (5 x 5 = 25) obtained as follows:

I t − D =  (Yt − Yt −1 ) = Y
= 5(105 – 100)
= 5(5) = 25

And change in capital is 25 and the new capital stock is

Kt+ Kt – 1 = 500 + 25 = 525

Kt+ Kt – 1 = 525

Thus, the capital stock of the economy must be 525 Birr

In its simplest form, the theory has a number of limitations.

a. First, the theory explains net investment but not gross investment because for the determination
of aggregate demand gross investment is the relevant concept.

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b. Second, the theory assumes that a discrepancy between actual and desired capital stocks is
eliminated in a single period, which may not be true. That means there may always be deviation
between the desired level of capital and the actual level.

c. Third, this theory assumes that there is a fixed relationship between capital and output given by
the constant value  . However, in real situation there is possibility of substituting capital to
labour within a limited range. If this concept of substitution is true then the concept of fixed
capital – output ratio is not valid.

7.7.2. The Internal Fund Theory of Investment

Dear Learner! The central view of this theory is that investment depends on the level of profits.
The managers have a preference for financing investment internally. Firms can obtain finance to
fund investment through various sources such as retained earnings, depreciation expense, various
types of borrowings, sales of stocks etc. The first two sources are internal to the firm and others are
external to the firm. If the firm opts for external borrowing, then it needs a series of fixed payments
to return borrowings. During recession, when economy does not perform well the firm may also
not be performing well and firms may not fulfil the commitment to pay. Similarly selling of stocks
has a chance of losing control. For these reasons, the proponent of internal fund theory argues that
firms strongly prefer to finance investment internally and that the increased availability of internal
funds through higher profits generates additional investment.

Hence, this investment theory implies that investment level is not determined by the level of interest
rate or cost of borrowing as suggested several government policy makers and central banks.
According to the proponents of this theory, regulating the level of interest rate does not help achieve
the required level of investment. This is because the major determinant of the level of investment
is the level of profit that investors can make.

Dear learner! Can you explain the policy implication of these theories? ---------------------
---------------------------------------------------------------------------Well done.

Suppose policy makers are interested in increasing investment. Internal fund theory holds the view
that profits should be increased. Policy makers can do this by reducing corporate taxes and

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reduction of income tax. This simply means that firms can invest and income earners can buy goods
and services produced by the firms. Thus, the policy action should not be reducing interest rate;
rather it should be reducing tax rates on investment and on sales of its products.

7.7.3. Tobin’s - Q theory of Investment

The q-theory of investment creates linkage between investment and stock market. According to
this theory, the price of the shares in any company is the price of a claim on the capital in the
company. The managers of the company are believed to be responding to the price of the stocks
by producing more new capital by investing. The investment is dependent on the share prices. If
the share price is high, investment will be high and vice versa.

‘q’ is an estimate of the value of the stock that market places on (or market gives to) a firm’s assets
relative to the cost of producing those assets. In other words, q is the ratio of market value of the
firm to the replacement cost of capital. Mathematically

Market value of the firm (x)

q=
Re placement cost (y)

Replacement cost is the cost that firm would get when it sells all its capital. When the value of q is
high (or x > y), firms will want to produce more assets, so investment will be high (the firm replaces
its old capital goods since the market values it at larger price). When the value of q is low (or x <
y), firms will want to produce less assets, so investment will be low (the firm will not replace the
old capital goods because its market valuation will be at lower value). Whenever q >1, firm should
add physical capital because it is profitable for the firm to do so because marginal product of capital
is greater than its real cost (MPk > Real cost). Thus, Tobin’s q theory is another form of explanation
of the neoclassical model of investment (see neoclassical theory of investment).

The investment decisions in this case are as follows:

 If q > 1, investment continues until marginal q falls to 1 because investing in capital pays more
than its cost to acquire and install the investment goods.

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 If q <1, the firm should reduce the capital stock by disinvestments (saving some part) or letting
depreciation take its course. Moreover ‘q’ theory tries to address the following points
which are considered in investment decision.
These are:

1. Lags and adjustment costs are inherent in selecting and implementing any capital investment
project. Investments which give product or return sooner are preferred to those investments
which give results after longer period.

2. Expectations about future costs and pay offs are also important. Expected higher cost of capital
in the future induces more investment currently. This is an attempt to avoid future higher
expense.

3. There is risk and its evaluation by the market. Individuals are more reluctant to invest in risky
investment goods.

This theory implies that firms have choice to invest in real assets or financial assets. This means
that the choice is to purchase the capital good (or investment good) or to keep the finance or the
money in the form of saving depending on the above principles of investment conditions.

7.7.4. Neo-classical Theory of Investment

According to neo-classical theory of investment, investment is based on benefit and cost of the
investment activity to a firm or firms. This theory assumes that firms borrow capital at a rate (R)
from the owner of the capital and sell its product at price P. Then we can say that the cost of capital
R
is equal to   . In terms of benefit, we can get the productivity of the capital, which goes down
P
with more investment at margin.

R
 Real cost =   . This cost has the shape of normal cost curves function which is increasing or
P
upward sloping.

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 Real benefit is measured in terms of marginal productivity of capital (MPK). The curve
measuring this benefit is down ward sloping since marginal product of a factor of production
including capital declines as the level of employment of the factor increases.

 The level of investment has to keep on increasing as long as the benefit of doing it is greater
than the cost of doing so or the cost of the investment activity. This implies that the invest level
should increase up to the level where the real cost of investment equals its marginal benefit
given by marginal product of the investment good or capital. This is represented by the point of
R
intersection between the cost   curve and the benefit, (MPK) curve given by point ‘e’ in the
P
following figure 7.6. The firm employ capital up to ‘e’ where R/P = MPK R = P (MPK).

This implies that firms should invest up to the level when the marginal benefit is exactly equal to
the marginal cost of production. This is achieved at point ‘e’ where marginal benefit is equal to the
marginal cost of production. However, at point “a” the investors gains more by paying less and
there is justification to increase investment. This theory implies also that it is better to focus on
factors that affect benefit of investors such as improving capital efficiency, lowering taxes on the
investment products and of course keeping lower market interest rate.

Figure 7.6: Neo -classical optimal investment level

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7.7.5. Inventory investment

Firms would invest in inventory for different reasons. Some of these are:

 To smooth the level of production over time. The demand for goods may highly fluctuate and
producers or sellers fill the gap created through inventory investment. This is because;
fluctuating or changing production along with demand may be costly. And such the remedial
measure is called product smoothening.

 To operate more efficiently. Goods on hand to show customers (for display) and keeping spare
parts to replace damaged machines would be efficiency improving.

 To avoid stock out. That means to avoid running out of stock for sudden increase in demand.
The process is called stock out avoidance.

 To help Production process. When production involves a number of steps, partially processed
goods are stored as inventory, called work- in -process.

Dear learner! Before concluding this section, let us explain how some economic environment
affects some investment objectives and list some other variables that affect investment such as
inflation and government debt, fiscal policies, trade or exchange rate policies and so on.

Better performing economic environment affects most of the investment types positively. For
instance, during economic boom the higher income leads to higher demand for residential house
and to an increase in residential investment. Higher level of output also leads to high inventory
keeping.
A. Acceleration and Stabilization Policy

Accelerator government actions or (for instance increased government expenditure) poses difficulty
for short run stabilization policy. In the short run (1st period), a given level of Y implies a given
level of capital. That is an increase in government expenditure doesn’t immediately lead to an
increased capital. Rather it leads to temporary overshooting (increased interest rate, temporary
inflation, reduced investment etc.).

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B. Capacity utilization and the accelerator

With substantial excess capacity (operating below capacity), accelerator may not work. For
example, an increase in government expenditure (fiscal Policy) increases employment of excess of
the excess capital towards actual employment and there will be no effect on net investment. This is
simply change of form of investment, but not new.
C. Demand constraint and accelerator

During the time, when there is demand constraint prices are slow to adjust. Introducing accelerator
during this period will not be working; firms see a sales constraint along with demand. This would
negatively affect the investment.
D. Inventories and real interest rate

Fiscal policy is a stimulus in a period of relative slack in economy, but reasonably high-capacity
utilization will be complemented by (or needs) an increase in investment. The real interest rate
measures the opportunity cost of holding inventories. Holding inventories for future sale involve
opportunity cost of receiving interest income on money by selling now and saving the money. Thus,
the level of inventory investment is low during the period when interest rate is high.

7.8. Some Determinants of Investment in Less Developed Countries

Dear learner! Can you list some of the determinants of investment in LDCs?

Investment in developed country is a function of profit and interest rate = f (τ, i). However, there
are other several determinants of investment in developing countries. Some of these factors are
fiscal policy, exchange rate policy, trade policy, level of financial deepening (financial
intermediation) and External debt. All of these factors exert their own impacts profitability of
investment in less developed countries. But since they depend on their own market these impacts
are less in developed countries.

a. Inflation

Dear Learner! Do you know the difference between actual and expected inflation?
Both actual and expected inflations affect the investment level.

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➢ Expected Inflation: - If firms expect future inflation, they move liquid asset to the real asset
(investment) called Tobin-Mundell effect. In principle, expected inflation encourages
investment. In less developed countries because of lack of capital market, people may change
domestic currency to foreign currency (resulting in capital flight). Or they invest in real assets
like land. This means that in less developed countries such as Ethiopia, expected inflation does
not necessarily encourage investment.

➢ Actual Inflation: - Actual inflation cause loss of confidence in currency and lead to capital
flight. Inflation leads to an increase in interest rate which means higher capital price (expensive
capital) which again discourages investment.
b. Fiscal Policy

Dear Learner! Do you know the major components of fiscal policy?

The major components of fiscal policies are taxation and government expenditure. Tax affects the
investment through two channels: direct and indirect channels. The direct channel is that a reduced
tax increases the profit, which in turn initiates investment and vice-versa. Higher tax indirectly
encourages investment as it increases the government saving which in turn make the loan cheaper
for better investment and vice-versa.

Increased government expenditure leads to an increased interest rate, which has a crowd out effect
on private investment. That means, an attempt of government to improve investment through its
own involvement in the investment activity may require the government to borrow from banks or
to cut government saving. And this pushes the interest rate up and reduces private investment.

c. Exchange rate policy

One of the major policy instruments in relation to exchange rate policy is devaluation. Devaluation
has two major distinct implications for developing countries under different situations. These are:
1. If our target is domestic market, import becomes expensive. This implies that cost of production
increases and investment declines. So, finally this discourages investment in domestic market.
2. If our target is foreign market, we do not know the effect on cost of predation and on investment.
As this increases market size, it may encourage investment.

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d. Trade policy
There are two major types of trade policy inward looking (called import substitution policy) and
outward looking (export promotion policy)

✓ Inward looking (import substitution policy)

Inward looking policy may be protecting investors from stiff competition of world producers. If a
government gives incentives for investors for definite time (protects for definite time) it encourages
investment. However, if the protection is for indefinite time, it may reduce efficiency of domestic
producers and so discourage investment
✓ Outward looking (export promotion)
There is always reciprocity (retaliation) in international trade. This means the country imposes low
tariff. If the firm is competitive at initial stages, a decrease in tariff (low tariff in importing country)
increase profit and this in turn initiate or encourage investment. However, for uncompetitive firm a
decrease in import tariff means cheap imports which crowds out the domestic ones and discourages
investment.
e. The impact of government debt on investment
In less developed countries, the government is overburdened due to excess debt. Excess debt is a
situation when government spends more than the income. Generally, negatively affects investment
in two ways.
✓ Through debt financing/ Debt servicing
During the debt period, there is always amortization and interest payment. This makes financial
resource unavailable for investment. For instance, if due to debt government pays the interests in
terms of foreign exchange, then there will be shortage of foreign exchange for import of raw
materials for new investment. So, this reduces investment spending.
✓ Through debt stock
Under high debt stock, investors expect higher tax by government in order to finance the debt in
future (to pay back the debt). As it is known that higher taxes discourage investment, the investors
may not come forward to invest. A country with high debt stock is risky to invest in. Foreign
investors are reluctant to do which in turn leads to lower overall investment. Moreover, if a country
has high debt stock, its credit worthiness would diminish (lose credibility) in international financial
market. This implies that there will be shortage of foreign exchange loans for new investment.

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f. Financial Flows
In less developed countries, there is foreign exchange constraint and producers are dependent on
imports. Moreover, there is closed capital account convertibility where there is no free capital
movement. This constrains import of capital goods which may be important for investment. Such
environment generally constrains investment.
g. Financial Intermediation (Financial deepening)

Some measurements of financial deepening are:

 Money - GDP ratio. High value of this ratio indicates the existence of financial deepening.
 Banks - (user) person ratio. High value of this ratio is also an indicator of financial
deepening.
High financial deepening means low cost of borrowing and encourages investment. In less
developed countries, there are several other factors explaining investment. For instance,
infrastructure is assumed to be there in above discussion. But its absence and macroeconomic
instability, civil wars, etc. complicate the cause effect relationship.

Self-test
1. What is paradox of saving?
2. Why people invest on inventory?
3. Explain the neo classical theories of investment?
4. How does inflation affect investment?
5. Which trade policy will increase investment in Ethiopia?
6. How does exchange policy affect investment in Ethiopia?

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Unit Summary
 Investment can be defined as the process of putting one’s resource (money) in a given system
with expectation of some benefits (more income, some products for sale or for consumption and
satisfaction).
 Investment is considered as an important part of national income accounts.
 The determinant of investment are; Market demand (required for investment in production);
financial resource; political factors (political stability); level of uncertainty (level of risk);
availability and efficiency of banking system (credit or lending institutions); government
economic or investment policy and interest rate (cost of borrowing).
 There are two Motive of Investment; those are profit motives and non-profit motives. Profit
motive investment is mostly done by private while non-profit private investment is done by
government and NGOs.
 Crowding effect represents the case where the government action such as fiscal policy or
government investment activity itself reduces the investment in the private sector.
 Interest rate can be affected by the level of saving; level of income; investment. Money supply.
 Investment spending is on the demand side where as saving is on the supply side of investment
and finance sectors.
 Firms would invest in inventory for different reasons. Some of these are: to smooth the level of
production over time, to operate more efficiently, to avoid stock out, to help Production process.
 According to neo-classical theory of investment, investment is based on benefit and cost of the
investment activity to a firm or firms.
 Inflation, fiscal policy, exchange rate policy, trade policy and government debt are among the
major determinants of investment in Less Developed Countries.

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Suggested Reference
✓ Ackley, G. (1987) Macroeconomics: Theory and Policy, New York McMillan Publishing
✓ Branson, W. (2006) Macroeconomic Theory and Practice, 3rd ed. New Your Harper & Row
Publisher.
✓ Colander, 2001. Macroeconomics 4th edition New York.
✓ Dombusch, R. and S. Fischer (1994) Macroeconomics, 2nd ed, New York: McGraw-Hill
International Edition.
✓ Dornbusch R, Fischer, S and Richard, S. (1999) Macroeconomics, (7th ed.), New York,
McGrew-Hill international edition.
✓ Eduard Shapiro, (2000). Macroeconomic Analysis, (5th ed.), New York, Harcourt Brace
Jovanovich, Inc,
✓ Frederick Mishkin, 1998. The Economics of Money, Banking and Financial Markets (5th ed.)
USA.
✓ Irvin, B. (1997) Macroeconomics for Today, USA, West Publishing Company
✓ Mankiw, G. (2005) Macroeconomics, 7th ed, Worth publishing USA
✓ N. Gregory Mankiw, (2007), Macroeconomics, (4th ed.), Worth Publishers, USA
✓ Olivier Blanchard, [Link] Prentice Hall Inc. New jersey USA
✓ Pentecost, E. (2000), Macroeconomic: An open Economy Approach, Macmillan press Ltd.
✓ Steven, E and Lauren, J. (1997), Macroeconomics, USA, McGrew-Hill companies.

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