CHAPTER THREE
MACROECONOMIC PROBLEMS
AND POLICY INSTRUMENTS
Instructor: Mohammed Hassen
Chapter Content
o business cycle,
o unemployment, and
o inflation.
3.1. Business Cycles?
3.1.1 What are Business Cycles?
 Business cycle or trade cycle refers to the regularly occurring
fluctuations in economic activity in market economies.
 It refer to alternating period of expansion & contraction in economic
activity.
 In a business cycle, there are wave-like fluctuations in four interlinked
economic variables: employment, income, output and price level.
 When the values of these economic variables over time are plotted on a
graph, we get a wave-like figure, which is called business ‘cycle’.
 They are often called business fluctuations.
3.1.2 Phases of Business Cycles
 Economists have identified four distinct phases
of business cycles. These are:
 Peak (or boom)
 Contraction (or recession)
 Trough (or depression)
 Recovery (expansion)
What are these four phases?
i. Boom: This is a phase of economic activity characterized
 By rising demand, rising prices, rising investment, rising
employment, rising incomes, rising purchasing power, etc.
 Business continues to remain profitable.
 More loans are taken from banks and financial institutions.
 As a result of excess demand of loanable funds there occurs
rise in interest rates. The investors, voluntarily undertake
risks and go for investment, which further fuels boom
conditions through the working of the multiplier effect.
 During the boom period, there is over-optimism in
business psychology, and thus the economy can get overheated.
 Peak is a period at which business activity has reached a
temporary maximum.
 It is the period of high employment, high level of demand,
and high degree of utilization of resources.
 The price level is likely to rise during this period.
ii. Contraction or Recession: This phase corresponds to:
 The contraction or slowing down of economic activity.
 During this phase unemployment rises while sales, income
and investment all fall.
 Producers become pessimistic about the future level of
demand for their products and hence investment becomes less
attractive.
Thus, there may be cuts in investment, resulting in cuts in
employment, a fall in incomes, and declines in purchasing
power and demand. Prices may then begin to fall.
iii. Depression: A depression is a period of
 Low economic activity characterized by massive unemployment, low
level of consumer demand and widespread idle capacity in industry.
 Most prices will be falling.
 Business profits will be low or even negative.
 Investment will fall due to lack of confidence of the businessmen.
 There will be low demand for loanable funds.
 Banks will have surplus funds because nobody is willing to take risk.
 This is a stage when the business confidence is at its lowest.
Investment, employment, output, income, & prices reach bottom.
iv. Recovery: As the economy moves out of depression, it enters the
phase of recovery.
 In a sustained recovery,
 The level of investment, employment, output, income and prices move
upwards.
 Now businessmen replace old and worn-out machinery.
 Employment, income and consumer spending start rising.
 The rise in production, sales & profits yield place to business
optimism.
 So, existing labor forces and unused capacity are pressed into service.
Prices either stay constant or start rising during the recovery period.
Cyclical nature of Business cycle
3.1.3. Characteristics of Business Cycles
 The following are some of the characteristics of business cycles:
1. 
Business cycles are the wave-like fluctuations in economic
activity as reflected in basic economic variables like employment,
income, output and price level.
2. Business fluctuations are cyclical in nature.
3. The sequence of changes in a business cycle recur frequently and
in a fairly similar pattern.
4. 
Periodicity between the cycles need not be same or similar,
5. Business cycles are fluctuations found in overall economic
activities, and are not limited to any particular firm or industry,
6. 
Normally, if the boom is high the succeeding depression will
also be severe. However, this relationship might not hold
good in the reverse,
7. 
Business cycles usually last for a period of 2 to 10 years. But
their duration differs.
 Sometimes a major depression may last for more than a
decade; at other times the down turn may be brief. It may
last for 2-3 years. The great depression of 1929 lasted for
3-4 years.
3.1.4. What are the possible causes
of business cycles?
i. Major Innovations
 we means the introduction of new product or a new
process (a new method of producing an old product).
 These, in turn, affect output, employment, and the price
level. These major innovations occur irregularly and thus
contribute to the variability of economic activity.
 According to Schumpeter, business cycles are simply a
part of the capitalist system and cannot be eliminated.
ii. Political and Random Events
 Other economists have explained business cycles in terms of
political and random events. For example, wars, natural
disasters, conflicts, and civil strives can be economically
disruptive.
iii. Monetary Phenomenon
 According to R.G. Hawtrey view the business cycle is a purely
monetary phenomenon.
 When government creates too much money, they say, an
inflationary boom occurs. In contrast, too little money
precipitates a decline in output and employment.
 He attributed prime responsibility for business fluctuations to
monetary instability.
How monetary instability result in business cycle?.
 Let us start with a situation of recession.
 Hawtrey Monetary phenomenon implies that banks are
now flushed with funds (i.e., have excess reserves). They
extend loans at low rates of interest. This would stimulate
(encourage) investment.
 The increase in planned investment raises production and
income, raising sales. This signifies as the phase moves
from recession to expansionary(recovery) phase of
business cycle.
iv. Changes in total Spending
 The changes in level of total spending as the
immediate cause of cyclical changes in the levels of real
output and employment.
 In a market economy, businesses produce goods or
services only if they can sell them profitably.
 If total spending sunk, many businesses find that it is no
longer profitable to produce.
 Therefore, output, employment, and incomes will fall.
 In contrast, a higher level of spending means that more
production is profitable, and output, employment, and
incomes will rise.
Control of Business Cycles
 Cyclical fluctuations in economic activity cause a great deal of
harm to smooth & orderly progress of a modern mixed economy.
 So planners and policy-makers always make effort to bring them
under control.
 However, it has to be noted that business cycles are a part of our
lives and cannot therefore be completely eliminated.
 We can only hope to reduce their severity by adopting suitable
policies. These policies are known as stabilization policies and
are of two broad categories: monetary policy and fiscal policy
1. Monetary policy:
 Business Cycles are not a purely monetary phenomenon. But they
are aggravated by monetary factors.
 So, it is necessary to reduce money supply during expansionary
phase of the business cycle, when there is price inflation.
 Conversly, if the economy is in the depression phase, it is
essential to reduce the stock of money in the kazena and avail for
circulation in the economy.
 Various instruments such as the discount rate, open market
operations, reserve ratios, selective credit control, etc are used by
the central bank to control stock of money in circulation.
2.
Fiscal policy:
 A positive fiscal policy helps to compensate for the ups and downs
in economic activities.
 While the economy losses its dynamism and falls below the full
employment growth path, fiscal policy may be used to bring aggregate
demand back to the full employment level.
Taxes have to be reduced;
Gov,t expenditures increased and total spending ⇧
 When the economy shows signs of dynamism and there is danger of
inflation, an exactly opposite type of fiscal action is implemented.
It is, of course, not possible to eliminate recession or price inflation
altogether, but an appropriate compensatory fiscal policy can keep the
economy close to its full employment path.
3.2. Inflation
3.2.1.Meaning of Inflation
 Inflation is a continual and ongoing rise in general
or average price level on a specified period of
time.
 A birr today doesn’t buy as much as it did ten
years ago.
 Thus, it is a general terms, is described as a situation
characterized by a sustained increase in the
general price level. It may be noted thus:
 A small rise in prices or an irregular price rise
cannot be called inflation.
 It is a persistent and appreciable rise in prices
which is called inflation.
3.2.2.Causes of Inflation
 Inflation cannot be attributed to a single factor.
Rather, a mix of several factors is responsible for it.
Normally, these factors are divided into two
broad types:
 Demand-Pull factors and
 Cost-Push factors.
 Accordingly, based on this factors there are two
types of inflation which named as:
 Demand-Pull inflation and
 Cost-Push inflation.
1. Demand-Pull Inflation
 When the demand for goods and services exceeds
the available supply at current prices, the situation
is described as “too much money chasing too few
goods”.
 The
various
causes
for
demand-pull
inflation
include:
 An increase in government expenditure: This increases
the demand for goods and services, and hence, is
responsible for price rise.
 An increase in money supply: Such a situation is
followed
by
rises
in
prices.
Money
purchasing power over goods and services.
represents
 An increase in investment: When this is done by the private or
public sector it leads to a large demand for goods and services,
which is followed by price rises.
 An increase in wages: Particularly when this does not match a
corresponding increase in productivity, it increases the general
price level.
 Black money: Such money, which is normally spent on nonessential goods and services, plays an important role in pushing
up the prices in a country.
 Deficit financing: This is an important factor for rises in money
supply and therefore for rises in price level.
 Credit expansion: As a result of credit expansion, people buy
more goods, leading to increases in the demand for goods and
this leads to increase in the prices of goods.
2. Cost-Push Inflation
 Inflation resulting from rising costs of production and slack
resource utilization is called cost-push inflation.
 This is sometimes also known as supply-shocked inflation.
 It happens in agricultural and industrial production due to
various reasons such as
 shortage of raw materials,
 power breakdowns,
 strikes and lockouts,
 bad weather conditions,
 increase in input prices, etc. – lead to a decreased supply of goods in
comparison to their demand, which further leads to price rise.
 Hording- when firms and household engage in speculative activities.
3.2.3.Measuring Inflation
 Measuring inflation means a measurement of variations in
general price level.
 Economists measure changes in the cost of living using the
price indexes.
o producer price index,
o consumer price index
o GDP deflator
 The Consumer Price Index (CPI) is the most widely accepted
index for measuring the rate of inflation, since it measures the
average price of goods and services bought by general
consumers.
 CPI measures the cost of a “market basket” of
consumer goods and services in current time relative to
the cost of that bundle during a particular base year.
The base year is a reference year.
CPI=
Cost of market basket of goods at current prices
*100%
Cost of the same basket of goods at base year prices
 Rate of inflation measures the extent of the increase
in the general price level over time.
 It is usually measured as the percentage change in
the general price level from one year to the next.
 Example1.
The consumer price index (CPI) in
December 102 was 168.9, and the CPI in December
2013 was 174.6. The inflation rate for 2013 is the
percentage change in prices from the end of
December 2012 through the end of December 2013.
Infilationrate() 

CPIt  CPIt 1
*100%
CPIt 1
174.6  168.9
*100%
168.9
 3.37%  3.4%
 This means the inflation rate in 2013 was
approximately 3.4 percent.
3.2.4.The impact of inflation
3.2.4.1.The Effects of Inflation on the Society
 Inflation affect the society since it reduce the
purchasing power of their money.
1. The Costs of Expected Inflation
 Suppose that every month the price level rose by 1
percent. What would be the social costs of such a
steady and predictable 12-percent annual inflation?
A. One cost is the distortion of the inflation tax
on the amount of money people hold.
 As we have already discussed, a higher inflation rate
leads to a higher nominal interest rate, which in turn
leads to lower real money balances.
 If people are to hold lower money balances on
average, they must make more frequent trips to the
bank to withdraw money.
 For example, they might withdraw birr 100 twice a
week rather than birr 200 once a week.
 This result in shoe-leather cost of inflation, because
walking to the bank more often causes one’s shoes to
wear out more quickly.
B. Menu-cost.
 Changing
prices
is
sometimes
costly:
for
example, it may require printing and distributing
a new catalog.
These costs are called menu costs because the
higher the rate of inflation, the more often
restaurants have to print new menus.
C. Inefficiency in resource allocation .
 For example, suppose a firm issues a new catalog
every January. If there is no inflation, then the firm’s prices
relative to the overall price level are constant over the
year.
 However if inflation is 1 percent per month, then from
the beginning to the end of the year the firm’s relative
prices fall by 12 percent.
 Sales from this catalog will tend to be low early in the
year and high later in the year. Hence, when inflation
induces variability in relative prices, it leads to
microeconomic inefficiencies in the allocation of
resources.
D. A fourth cost of inflation may result from tax laws.
 Many provisions of tax code do not take into account the
effects of inflation.
 Inflation can alter individuals’ tax liability, often in ways that
lawmakers did not intend.
 Suppose you buy some stock today and sell it after a year
from now at the same real price. It would seem reasonable
for the government not to levy a tax, because you have
earned no real income from this investment. This implies , if
there is no inflation, a zero tax liability would be the
outcome.
 But suppose the rate of inflation is 12 percent and
you initially paid birr 100 per share for the stock; for
the real price to be the same a year later, you must
sell the stock for birr 112 per share.
 In this case a tax code that ignores the effects of
inflation, says that you have earned birr 12 per share
in income, and the government taxes you on this
capital gain.
E. A fifth cost of inflation is the inconvenience of living in
a world with a changing price level. For example, a
changing price level complicates personal financial
planning.
2
. The Costs of Unexpected Inflation
 Unexpected inflation has an effect that is more
harmful than any of the costs of anticipated inflation:
Let us it see using different cases.
 Firstly, consider long-term loans. Most loan
agreements specify real interest rate, which is based
on the rate of inflation expected at the time of the
agreement.
 If inflation turns out to be higher than expected, the
debtor wins and the creditor loses because the
debtor repays the loan with less valuable dollars.
 On the other hand, if inflation turns out to be lower
than expected, the creditor wins and the debtor loses
because the repayment is worth more than what the
two parties anticipated.
 Secondly, unanticipated inflation also hurts individuals
on fixed pensions. Workers and firms often agree on a
fixed nominal pension when the worker retires (or even
earlier).
 Like any creditor, the worker is hurt when inflation is
higher than anticipated.
 Like any debtor, the firm is hurt when inflation is lower
than anticipated.
3.2.4.2.The Impact of Inflation
On Economic Growth
 Inflation has different levels or degrees of severity,
described as moderate, galloping, and hyper inflation.
 A moderate inflation is generally believed to be a
necessary condition of economic growth. A state of zero
inflation rate is not expected to yield the desired growth
rate in the case of a developing economy.
 However, It may be noted that unchecked inflation may
change into hyper-inflation may also retard economic
development in a number of ways. It may lead to
lopsided development; lead to increased consumption
and have a negative effect on savings; have an adverse
effect on the balance of payments; and introduce
uncertainty and instability.
 For a better understanding of the impact of inflation on
economic growth, we classify these effects into two
categories: favorable effects and adverse effects.
1.Favourable Effects or positive effects of Inflation
 Mild inflation has some favorable effects on production,
capital formation and economic development. Some
such favorable effects are the following:
 Effect on Production: When prices are rising, profit
expectations become brighter and thus investment
climate becomes favorable. Therefore the entrepreneurs
undertake new investments, set up new production units,
and expand the existing plants. All these lead to greater
production.
 Effect on Capital Formation: Rising prices bring in higher profits to
the capitalists. In turn, a greater part of these profits is reinvested
with a view of earning further profits. Thus, investment increases
and rate of capital formation becomes higher.
 Effect on Employment: Rising prices lead to increased investment
by the entrepreneurs in various sectors of the economy with a
view to producing and selling larger quantities of goods and
services, and thus further adding to their profits. Increased
production requires more labour and other resources. Thus
employment of labor also increases.
 Effect on Economic Development: Rising prices that raise profit
expectations, build up favorable investment climate, and
increase production and employment, thus lead to an increase
in the growth rate of national income and raise the pace of
economic development.
 Inflation may be Self-Liquidating: As stated above, a
slow and mild rate of inflation helps to increase
investment, production and employment. It increases
the tempo of development.
 Thus, over a period of time more goods flow from the
farms and factories, and the overall supply in the
economy increases. Since inflation is caused by an
excess of demand over supply, the supply will increase
after some time and become equal to demand. The
prices would thus fall due to increased supply, and
inflation would end. Thus, inflation can be selfliquidating.
2. Adverse Effects or Negative effects of Inflation
 Many times, inflation becomes self-sustained. Then the price level
keeps on increasing continuously over a long period of time.
 Accordingly, inflation starts showing its adverse effects, some of
which are the following:
 Income Effect: Inflation adversely affects fixed-income groups like
wage and salary earners and those whose income consists of
rent from property or interest on loans. The wages and salaries are
fixed payments which do not increase with prices. Thus, when
wages remain more or less fixed, rising prices continuously reduce
purchasing power and hence the wage and salary earners suffer
a loss in real income.
 The same is the case with other fixed incomes like rents, interest,
etc., which are contractual payments and do not increase with
rising prices.
 Saving Effect: With a rise in prices, the purchasing power
of money declines. Thus more money has to be spent to
buy the same amount of goods and services. This reduces
the level of savings out of a given level of income.
 Redistribution Effect: Under mild inflation or a continued
slow rise in prices, profits keep on increasing. As wages
and salaries remain more or less fixed, income of the
industrial and business classes increases relative to the
income of working classes. Thus, there is a redistribution of
income in favor of the rich capitalists and business
people, and therefore, the gap between the rich and the
poor become wide and results in income inequality.
 Price-Wage Spiral: Due to rises in prices, labourers
demand higher wages. If this demand is fulfilled, the
increase in wages leads to a further rise in prices. The
rise in prices, in turn, leads to further rises in wages. This
creates a vicious circle of wage and price rises.
 Effect on Economic Planning: A plan is prepared, say
for five years ,in which targets are fixed and resources
are mobilized and put in the planned channels of
production to achieve these targets.
 If prices start rising, then the actual cost of inputs to be
used for achieving production targets becomes
higher, and hence more financial resources are
needed.
 But under inflation, savings get reduced and, at the
same time, it becomes more difficult for governments
to impose new taxes to collect more revenue. Hence,
plan targets are either curtailed or most of them
remain beyond reach(or postponed), thereby
upsetting the whole planning process.
 Effect on Balance of Payments: Balance of payments shows
how much a country has to receive from the rest of the world
as payment for goods and services it has exported and how
much it has to pay for imports from other countries.
 When total payments are more than the total receipts, it is
called a balance of payments deficit.
 With inflation or rising prices this deficit increases. This is
because under prevailing high prices, foreigners will not buy
our high priced goods. So, our exports will fall. On the other
hand, our people will buy more of the relatively cheaper
foreign goods, thereby increasing our imports. Since imports
are more than exports, it means that the country has to make
more payments than what it receives. Thus the deficit in
balance of payments increases.
 Remarks: Besides these, effects rising
prices encourage speculation and
hoarding,
profiteering,
corruption,
strikes, social unrest, and many more
problems.
 It is therefore necessary that inflation
should be controlled and prices
stabilized or allowed to rise only within
narrow limits.
3.3. Unemployment
 Unemployment is the macroeconomic problem that
affects people most directly and severely.
 For most people, the loss of a job means a reduced living
standard and psychological distress.
3.3.1. Measuring 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.
Cont’d
 To understand how unemployment can be measured, we
have to understand the following concepts
 i. Employed: A person who have a paid job and actively
participate in it. It refers to any arrangement by which a
person earns income or a means of livelihood. Such as:
a. In the form of self-employment: Examples of selfemployment are the activities of shopkeepers, traders,
businessmen, professionals, etc.
b. By offering their labour services to others and in return
get wages. It is called wage-employment. In this case, the
supplier of labour (worker) is called employee and the buyer
of the labour is called an employer.
Cont’d
ii. Unemployed: refers to a situation where the persons
who are able to work and willing to work, at the
current market wage rate, fail to secure work or
activity which gives them income or a means of
livelihood.
iii. The labour force is defined as the sum of the
employed and unemployed.
Labour force = No. of Employed persons + No. of
Unemployed persons
Cont’d
 N.B. From the total population of the country the following items
are excluded to compute labor force.
 Total population minus(-)
 children(below 15 age),
 old persons(above 60 age),
 individuals who are unable to work(willing but fully disabled/Sick)
Equal to (=)
 number of those who are able to work.
Minus(-)
 who are not willing or are not available to work.
Equal to (=)
 labour force
iv. Unemployment rate: is equal to the number of
unemployed persons divided by the labor force.
 Unemployment rate is the statistic that measures the
percentage of those people wanting to work but who do
not have jobs.
Unemployement , rate 
No.ofunemplyed
*100%
Labourforce
v. Labour-force-participation rate: the ratio of this labour
force to the adult population is called the labour-force
participation rate. This gives us the number of people who
are able to work, willing to work and available for work.
Labourforce
Laborforce, participation, rate 
*100%
Adult , Population
Illustration
Suppose the Statistical Authority in Ethiopia have
the following result from the census taken in 1994.
The number of unemployed is 20 Million, employed
30 Million and adult population 60 Million.
Find
Labour force
Unemployment Rate
Labour-Force Participation rate
 Solution
a. To find the Labour Force;
 Labour Force= Unemployed + Employed
= 20 Million + 30 Million
= 50 billion
 Then;
b. Unemployment Rate
No.of .Unemployed
Unemployement , rate 
*100%
Labourforce
(20 Million/50 million)*100%
c. Labour-force participation rate
Labourforce
Laborforce, participation, rate 
*100%
Adult , Population
(50 Million/60 Million)* 100%
3.3.2.Types of Unemployment
 In economics, three different types of unemployment are
identified- frictional, structural, and cyclical.
1. Frictional Unemployment :is temporary unemployment
which exists during
a period of the transfer of labour from one occupation to
another.
Locational preferences
When students searching for jobs for short durations
after their graduation or
People reentering the labour force due to changed social
or family situations.
2. Structural Unemployment
 Structural unemployment refers to a situation in which
workers become jobless due to change in the pattern of
demand, leading to changes in the structure of production in
the economy. For example,
A change of energy use from coal to electric power is bound
to curtail coal mining activity and cause unemployment.
An increased use of synthetic rubber could reduce demand for
natural rubber & lead to unemployment in rubber plantations.
Since the person thus unemployed may not be in a
position to learn the technologies used in the newly
expanding industries, they may be rendered
permanently unemployed.
Thus, Structural unemployment signifies a mismatch
between the supply of and the demand for labor.
Note: Natural Unemployment: is the sum of
frictional unemployment
and
the
structural
unemployment.
3. Cyclical Unemployment
 ‘Cyclical unemployment’ is a form of unemployment
associated with cyclical fluctuations in economic activity
like ‘trade cycles’ or ‘business cycles’.
 For example during depressions, investment activities get
discouraged and hence contractions in business activities
renders large number of workers unemployed.
 Thus, cyclical unemployment arises due to inadequate
overall demand associated with the downswing, recession
or depression period of a business cycle.
3.4. Relationship between Macro Economic
Problems and Variables
3.4.1.The Business Cycle and the Output Gap
 Inflation, growth & unemployment are related through the business
cycle.
 The business cycle is the more or less regular pattern of expansion
and 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 and
economic activity is low relative to trend.
 Inflation, growth, & unemployment all have clear cyclical patterns.
Figure: Idealized Business cycle
3.3. Idealized Business Cycle
Peak
Real GDP per year
Peak
Trough
Recession
Recovery
Amplitude
4
 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.
 Therefore, Output is not always at its trend level rather output
fluctuates around the trend level.
 For example during expansion the employment of factors of
production increases, and that is a source of increased production.
Conversely, during recession unemployment increases and less
output are produced than can in 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 b/n actual output & the output the
economy could produce at full employment of existing resources.
 Full employment output is also called potential output.
Output gap  potential output – actual output
3.4.2. Okun’s Law
 Named after its discoverer, Arthur Okun
 Because employed workers help to produce goods & services
and unemployed workers don’t, increases in unemployment
rate should be associated with decreases in real GDP.
 In general 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
Percentage change in real GDP
Growth and Unemployment Dynamics
12
9
6
3
0
-3
-3
-2
-1
Change in unemployment rate
0
1
2
3
3.4.3. Inflation –Unemployment Dynamics
 The Phillips curve describes the empirical relationship between
inflation and unemployment:
 The higher the rate of unemployment, the lower 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.
End of Chapter Three