JIMMA UNIVERSITY

COLLAGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS

MACROECONOMICS II (ECON 312)

LECTURE NOTE

By
Wondaferahu Mulugeta1

June 2009
Jimma
Ethiopia
1
The author is lecturer of economics, collage of business and economics, department of economics,
Jimma University
 CHAPTER ONE
SECTORAL DEMAND THEORIES AND FUNCTIONS
Introduction: How do households decide how much to consume today and in future?
We care about this decision because consumption is the largest component of aggregate
demand and saving is one of the determinants of growth. Thus, knowledge about how do
households arrive at this decision and what factors affect their decision making is critical.

1.1 Theories of Consumption and consumption expenditure

1.1.1 Keynesian Consumption theory: The absolute income hypothesis (AIH)
Keynes postulates three complementary propositions/assumptions:
1. Consumption will rise as disposable income rises. In other words, income is the
most important determinant of consumption. That is the higher the income of a
household the higher will be consumption.
2. The MPC is positive and less than 1. This is to mean the increase in consumption
will be smaller that the increase in disposable income. \in other words households
spend less that their total income
3. APC ( c / y ) is greater than the MPC but assumed to fall as income rises. The
implication is that on average the rich spend less of their income than (or saves
more than) the poor.

Algebraically, Keynes’s short-run consumption function is given by

−
c = c + βy ---------------------------------------------------------------- (1)
−
Where c is autonomous consumption and β is c ′ or the MPC and is greater than 1 (by
the first proposition). Graphically, the function is shown in Figure 1.1, which plots
consumption expenditure ( c ), against real income ( y ). This function indicates the
observation that as income increase people tend to spend a decreasing percentage of
income, or conversely tend to save an increasing percentage of income(by the second
proposition). The slope of the line from the origin to a point on the consumption function
gives the average propensity to consume (APC) or the c / y ratio at that point.

The slope of the function itself is the Marginal Propensity to Consume (MPC). From the
graph it is clear that the MPC is less that APC. If the ratio of c / y falls as income rises,
the ratio of increment in c ( ∆c ) to the increment in y ( ∆y ), or c ′ (MPC), must be
smaller than c / y . Keynes saw this as the behavior of consumer expenditure in the short-
run- over the duration of a business cycle- reasoning that as income falls relative to the
recent levels, people will protect consumption standards by not cutting consumption
proportionally to the drop in income, and conversely as income rises, consumption will
not rise proportionally.

2
 c E

c( y )
s1 B
c1 A

−
c

y
y1 y2
Figure 1.1: Keynes Consumption Function (absolute income hypothesis)

The line OE is the 45 0 line along which all income is consumed. At income level y1 ,
consumption is given by Oc 1 , while savings are given by Os 1 and represent that amount
of income not spent. The average propensity to consume ( c1 / y1 ) is represented by the
slope of line OA . The figure also represents APC declines as income increases. Suppose
now that income increased from y1 to y 2 . The APC is now given by the slope of the
line OB , which is less than the slope of OA and hence APC has declined.

The acceptance of the theory that MPC < APC ; so that as income rises c / y falls led to
the formulation of stagflation thesis around 1940. It was observed that if consumption
follows this pattern, the ratio of consumption demand to income would decrease as
income rises. The problem for fiscal policy that the stagflation thesis poses can be seen as
follows. If
c i g
y = c + i + g or 1 = + + ------------------------------------- (2)
y y y

is the condition for equilibrium growth of real output ( y ), and there is no reason to
assume that the ratio of private investment to income ( i / y ) will rise as economy grows,
then government expenditure to income ( g / y ) must rise to balance the consumer
expenditure to income ( c / y ) drops to maintain full-employment demand as y grows.

In 1946, Simon Kuznets published the first long-run time-series data for the USA for the
period 1869 -1929 a study on consumption and saving behavior dating back to the Civil
War (1865). Kuznets’ data pointed out two important things about consumption behavior.
First, it appeared that on average over the long-run the ratio of consumer expenditure to
income ( c / y ) or APC, showed no downward trend, so the MPC equaled the APC as
income grew along trend. This meant that along trend the c = c( y ) function was a
straight line passing through the origin as shown in Figure 1.2

3
 c
Long-run function: MPC = APC

Short-run function: MPC < APC

Figure 1.2: Long-run and short-run consumption functions

Second, Kuznets’ study suggest that years when the c / y ratio was below the long-run
average occurred during boom periods, and with c / y ratio above the average occurred
during periods economic slump (recession). This meant that the c / y ratio varied
inversely with income during cyclical fluctuation, so that for the short period
corresponding to a business cycle empirical studies would show consumption as a
function of income to have a slope like that of the short-run functions of Figure 1.2 rather
than the long-run functions. Thus, by the late 1940s it was clear that there were three
observed phenomena, which the consumption function must account for
1. Cross-section budget studies show s / y increasing as y rises, so that in cross-
section of the population MPC < APC
2. Business cycle, or short-run data show that the c / y ratio is smaller than average
during boom periods and greater than average during slumps, and hence in the
short-run, as income fluctuates, MPC < APC
3. Long-run trend data show no tendency for the to change over the long-run, so that
as income grows along trend, MPC = APC

In addition, the theory of consumption should be able to explain the apparent effect of
liquid assets on consumption. Therefore, the failure of Keynesian consumption function
to explain long-run behavior of consumption in cross-section studies and the effect of
liquid assets on consumption has motivated to the emergence of alternative consumption
theories in 1950s. Unlike Keynes, the theories that were developed by Fisher, Ando-
Modigliani, and Friedman have basic foundation in the microeconomics theory of
consumer intertemporal choice to explain these phenomena. In particular, Modigliani and
Friedman begin with the explicit common assumption that observed consumer behavior
is the result of an attempt by rational consumers to maximize utility by allocating a
lifetime stream of earning to an optimum lifetime pattern of consumption. Thus, we begin
the discussion of these three theories at their common points of departure in the theory of
consumer behavior and follow them individually as they diverge.

1.1.2 Irving Fisher’s model of consumption (the intertemporal choice)

4
Consumption is assumed to be the purpose of all economic activities. However, though
consumption theories before Fisher introduced some dynamics into consumption
behavior, they do not have sound micro foundation.

Fisher assumes that household’s utility depends upon its lifetime profile of consumption.
Hence, he began his explanation with a single rational consumer utility maximization
behavior as
U = f (c 0 ,..., ct ,..., cT ) --------------------------------------------- (1)

Where, lifetime utility U is a function of the individual’s real consumption c in all time
period up to T , the instance before he/she dies. The consumer will try to maximize
his/her utility, that is obtain the highest level of utility, subject to the constraint that the
present value ( PV ) of his/her total consumption cannot exceed the PV of his/her total
income in life. That is
T
yt T
ct
∑0 (1 + r )
t
= ∑
0 (1 + r )
t ------------------------------------------- (2)

Where, T is the individual’s expected lifetime. The constraint says that the individual
can allocate his/her income stream to a consumption stream by borrowing or lending, but
the present value of consumption is limited by the present value of income. We thus have
an individual with an expected stream of lifetime income who will want to spread that
income over a consumption pattern in an optimum way. We might imagine that his/her
expected income stream begins and ends low, with a rise in the middle, and he wants to
smooth it out into a more even consumption pattern.

To keep the analysis as simple as possible and formulate the problem in a workable
manner he assumed that the individual lives only for two periods: today; period zero and
tomorrow; period 1 (intertemporal choice). The two-period case utility of the household
for is thus given as:
U = u (c 0 , c1 ) ------------------------------------------------ (3)

Second, the household is assumed to maximize lifetime utility subject to the borrowing-
lending constraint imposed by its real wealth, where wealth is defined as the present
value of all future income streams. In a two-period model this is simply:

1
yt y0 y1
∑ (1 + r )
t =0
t
=
(1 = r ) 0
+
(1 + r )1
y1
A0 = y 0 + -------------------------------------------- (4)
1+ r
Where, A0 represents the household’s expected real wealth measured in terms of current
period (period 0); y 0 is this period’s real income; and y 1 is next period income
discounted by the real rate of interest, r .

5
Third, it is also assumed that the agent knows with certainty the expected future rate of
interest and that capital market is perfectly competitive. This means that the household
can either lend or borrow money as much as it wants at the going rate of interest without
affecting the rate. Forth, transaction cost is also assumed to be zero. Since this is a two-
period model and consumption is the sole determinant of economic growth (GDP), it
follows that lifetime wealth will be the constraint of lifetime consumption. Thus at
equilibrium, equation (4) can be
y c
y 0 + 1 = c 0 + 1 ---------------------------------------- (5)
1+ r 1+ r

Figure 1.3 shows the structure of intertemporal model. The vertical axis measures income
and consumption in period 1 while the horizontal axis measures income and consumption
in the current period (or period zero).

Period 1

y 0 (1 + r ) + y1
B

c1 E
U1

y1 A U0
y1
y0 +
1+ r

c0 y0 C Period 0

Figure 1.3: Two-period consumption case: utility maximization added

The budget constraint (BC) in the above graph indicates the maximum amount of lifetime
consumption. If the household is to consume its entire lifetime income stream in period
zero by borrowing against period 1, then the maximum amount that can be consumed can
y
be y 0 + 1 , which is the intercept of the budget line in period zero axis, point C .
1+ r
Conversely, if the household decides to consume nothing in period zero, delaying or
postponing all consumptions until period 1, then the maximum it can consume in period 1
is y 0 (1 + r ) + y1 , which is given by point B on period 1 axis. The slope of the budget

6
 constraint (line) is given by differentiating the wealth constraint for a given level of
interest rate, which is
y 0 (1 + r ) + y1
− y 0 (1 + r ) = y1
∂y1
= −(1 + r ) ------------------------------------------------- (6)
∂y 0

Point A in figure 1.3 shows that the amount of income the household will earn in period
zero, y 0 and the amount of income he/she will earn in period 1, y1 . The household has
also indifference map, representing preference for consumption in both periods and
given by lines U 0 and U 1 . The subscripts of U denote increasing level of utility.

The optimal consumption position for the household is thus given by indifference curve
labeled U 1 . From point E it is clear that the household saves in period zero for c0 < y 0
and dissaves in period 1 as c1 > y1 . That is the unspent income (saving) in period 0:
s0 = y 0 − c0 ≡ Money lent --------------------------------- (7)

By lending this amount, the individual will receive in period 1 an amount equal to
s 0 (1 + r ) , so that his/her consumption in period 1 can exceed his/her income by that
amount, which is his/her period 1 dissaving, s1
s1 = −(1 + r ) s 0 = y1 − c1 ------------------------------------- (8)

Since the slope of the indifference curve (IC), U 1 is equal to the slope of the budget line
at point E , the marginal utility of consumption (MUC) in period 0, ∂U / ∂c 0 to that in
period, 1 ∂U / ∂c1 , is exactly equal to −(1 + r ) . That is the MRS between consumption
in period 0 and consumption in period 1 is −(1 + r ) .

Furthermore, if the indifference curves (ICs) are homogenous of degree zero, then the
slope of all ICs are identical along the straight line passing through the origin. This
implies that the MRS of c 0 and c1 depends only on the ratio of c0 / c1 and not on the
absolute size of c 0 and c1 .

This assumption has an important implication that if consumption is not an inferior good,
one with negative income/wealth effect, then whenever a consumer received an extra Birr
worth of resource he/she would allocate it between c 0 and c1 in exactly the same
proportion as he/she allocated his/her original resource.

1.1.3 The Ando-Modigliani approach: The Life-cycle Hypothesis of consumption

7
In order to explain the three observed consumption function relationships discussed
earlier under 1.1.1, Ando and Modigliani postulate a life-cycle hypothesis. According to
this hypothesis:
• The typical individual has different income streams in his/her
lifetime. It is relatively low at the beginning and end of his/her life, when his/her
productivity is low and high during the middle of his/her life. This “typical” income
stream is shown as the y curve in figure 1.5, where T is expected lifetime
$
y
Adult

c = Average income
Youth Old

T Time

Figure 1.4: The ‘life-cycle’ hypothesis of consumption

• On the other hand, the individuals might be expected to maintain

a more or less constant/smooth or perhaps slightly increasing level of consumption
that maximizes his/her utility, shown as the c line in Figure 1.4 throughout his life.

The model suggests that in the early years of a person’s life, the first shaded portion of
Figure 1.4, the individual is a net borrower. In the middle years (when adult) he/she saves
to repay debt and provide for retirement. In the late years, the second shaded portion of
Figure 1.4, the individual dissaves. This is to say that their consumption level does not
vary with their income but with IC , and r .

Hence if the life-cycle hypothesis is correct then the high-income groups would contain a
higher-average proportion of persons who are high-income levels because they are in the
middle years of life, and thus have a relatively low APC ( c / y ) ratio. Similarly, the
low-income groups would include relatively more persons whose incomes are low
because they are at the end of the age distribution, and thus have high APC ( c / y ).
Thus, if the life-cycle hypothesis is true, a cross section study would show APC ( c / y )
falling as income rises, explaining the cross section studies showing MPC < APC .
Therefore, it seems reasonable to assume that in the absence of any particular reason (say
holiday, unforeseen events/contingencies like hospitalization, rise in payment bills, car
repairs, and the like) to favor consumption in any one period over any other, for
representative consumer ( i ) if PV i rises, all his/her consumption in period t ( cti ) rises
more or less proportionally. In other words, the Ando-Modigliani life-cycle hypothesis of
consumption for the i th consumer can be written algebraically, as
cti = k i ( PV t i ) ; 0 < k < 1 ------------------------------------------ (1)

8
Where, c is consumption; i represents an individual; t is time (in year); and PV
implies present value. On the other hand, k is a constant, which is assigned overtime to
indicate that an individual will spend certain proportion of his/her PV income and asset
values on consumption of goods and services. Here k i , the fraction of consumer i' s
PV he/she wants to consume in period t , would depend on the shape of the
indifference curve and the interest rate.

Equation (1) says that if an increase in any income entry, present or expected, rises the
consumer’s estimate of PV , he/she will consume the fraction of the increase in the
current period.

If the population distribution by age and income are constant, and tests between the
present and future consumption (that is the average shape of indifference curves) are
stable through time, we can add up all the individual consumption functions (1) and
obtain a stable aggregate function2:
c t = k ( PV t ) --------------------------------------------------------- (2)

The next step is to develop an operational consumption function from (2) is to relate the
PV term measurable economic variables3. The Ando-Modigliani began to make the
PV tem operational by noting that income can be divided into income from labour ( y L
) and income from asset or property ( y P ). That is,
T
y tL T
y tP
PV 0 = ∑ + ∑ t ------------------------------------- (3)
0 (1 + r ) 0 (1 + r )
t

Where, time zero is the current period and t changes from zero to the remaining years of
life of life expectancy of an individual ( T ), which is highly unpredictable.

Now, if capital markets are reasonably efficient, we can assume that the PV of income
form an assets is equal to the value of the asset itself, measured at the beginning of the
current period. That is,
T
y tP
∑0 (1 + r )
t
= α 0 ------------------------------------------------------ (4)

Where, α0 is real household net worth at the beginning of the period. Furthermore, we
can separate the known current labour income ( Y0L ) from the unknown (future or
(expected) labour income ( Yt L ). Then substituting (4) into equation (3) we get

2
Branson (1998) noted that the gradual change in age and income distribution in the U.S. since World War
II certainly meet the Ando-Modigliani assumption.
3
This is the crucial step in empirical investigation of the consumption function, as it is in almost any
empirical study in economics. The theory involves consumption as a function of expected income, which
of course cannot be measured.

9
 T
ytL
PV0 = y + ∑
L
0 + α 0 ---------------------------------------- (5)
t =1 (1 + r )
t

L
In equation (5), current labour income ( Y0 ) and the value of current wealth or assets (
α0 ) are known. But, the expected or future stream of labour income that flow overtime
T
y tL
during the lifetime ( ∑ t ) is unknown. The next step is this sequence is thus
t =1 (1 + r )

determining how the expected labour income ( Y1L ...YTL ) might be related to the current
observable variables. First, let as assume that there is an average expected labour income
e
in time zero, y 0 such that:
1 T y tL
y 0e = ∑
T − 1 1 (1 + r ) t
------------------------------------------ (6)4

Where, T −1 is the remaining life expectancy of the population up to retirement, which

is 37 (19 to 55 years) for an Ethiopian who joins the labour force at the age of 18 and
1
averages the present value of the future stream of labour income over T −1
T −1
years. Then the expected labour income term in expression 5 can be written as:
T
y tL
(T − 1) y 0e = ∑ t ----------------------------------------- (7)
1 (1 + r )

Substituting, the term in the left hand side of equation (7) into equation (5) we get
PV 0 = y 0L + (T − 1) y 0e + α 0 ------------------------------------- (8)

Equation (8) has only one remaining variable that is not measured - average expected
labour income; that is y e . We now need a final hypothesis linking average expected
labour income to a current variable – current labour income.

The simplest assumption Ando and Modigliani considered was that the expected average
income is just a multiple of present labour income; that is y 0 = β ( y 0 ) and β > 0 . This
e L

assumes that if current income rises, people adjust their expectation of future incomes up
to that y e rises by the fraction β of the increase in y L . We might note here that this
assumption assigns great importance to movements in current income as a determinant
of current consumption. Thus, substituting βy 0L for y 0e in expression (8) we obtain:
PV 0 = y 0L + (T − 1) y 0L + α 0
PV 0 = [1 + β (T −1)] y 0L + α0 ------------------------------------------ (9)
4
In equation (3.6), 1 indicates the first year an individual is entitled legally to be employed in formal
sectors. For instance, the constitution indicates that the minimum age for an Ethiopia to apply for a
vacancy and be employed in formal sectors is the age of 18. In Sweden an individual who has celebrated
his/her 16th birthday is permitted to engage in formal sector.

10
Where, β is a constant which represents the discount rate or by how much the future
stream of labour income will be discounted? Equation (3.9) is an operational expression
for PV in that both and can be measured statistically. Finally, substituting, equation (9)
into equation (2) for consumption we obtain a statistically measurable form of the Ando-
Modigliani lifecycle consumption function as:
c 0 = k [1 + β (T − 1)] y 0L + kα0 ---------------------------------------- (10)

For instance, the coefficients of y L and α in equation (10); that is the marginal
propensity to consume out of labour income and marginal propensity to consume out of
asset, were measured by Ando and Modigliani using annual U.S. date and obtained
ct = 0.72 y tL + 0.06αt ------------------------------------------------ (11)

The econometric result of Ando and Modigliani indicates that a $1 billion (or 1%)
increase in real labour income will raise real consumption by about $0.72 billion or the
marginal propensity to consume out of labour income by 72%. Similarly, the marginal
propensity to consume out of assets is 0.06 billion for an increase of households net
worth by $1 billion.

Comparing the estimates of the coefficients in (11) with the derived coefficients in (8),
we can see from the coefficient of α in equation 11, that is k is 0.06. This suggests,
from equation (2) that on aggregate, households consume about 6% of their net worth in a
year. Using this value for k equal to 0.06 and 45 years as a rough estimate of average
remaining lifetime ( T ), we can obtain the value of β (discount rate) from equation (10)
that is implicit in the estimate of the y L coefficient in (11):
0.72 = k [1 + β(T −1)]
0.72 = 0.06 [1 + β( 45 −1)]
0.72 = 0.06 + 0.06 [ β( 44 ]
0.72 − 0.06 = β( 2.64 )]
0.66 = β( 2.64 )]
0.66
β= = 0.25
2.64

This suggests that when current labour income ( y 0L ) goes by $100, in the aggregate, the
average expected labour income ( y tL ) rise by $25. Put differently, when current income
doubles (increases by 100%), then the expected labour income will rise by 25%.

The Ando-Modigliani lifecycle consumption function of equation (10) is shown in Figure

1.5 below, which graphs consumption against labour income. The intercept of the
consumption-income function is set by the level of assets; that is αt . The slope of the
function – the marginal propensity to consume out of labour income – is the coefficient
of y L in the Ando-Modigliani consumption function. In short-run, cyclical fluctuations
with assets remaining fairly constant, consumption and income will vary along a single

11
consumption-income function. Over the longer run, as saving causes assets to rise the
consumption-income function shifts up as kαt increases.

X
c

Slope = 0.72

kαt

0 yL
Figure 1.5: Estimated consumption function: Ando and Modigliani

Thus, overtime we may observe a set of points such as those along the line OX in Figure
1.5, which shows constant consumption – income ratio along trend as the economy
grows. This constancy of the c / y ratio can be derived from the Ando-Modigliani
consumption as follows. We can divided all the terms in equation (11) by total real
income to obtain
ct yL α
= 0.72 t + 0.06 t ----------------------------------------------- (12)
yt yt yt

If the c / y ratio given by this equation is constant as income grows along trend, then the
line OX , which gives the average propensity to consume c / y , will go through the origin
in Figure 1.5. The c / y will be constant if the y L / y - the labour share in total income –
and α / y - the ratio of assets or capital to total output/income – are roughly constant as
the economy grows along the trend5.

Ando and Modigliani noted that the observed data for the U.S. confirm that both the
labour share of income and the ratio of assets to income terms were fairly constant
around 76% and 300% (or simply 3) respectively. Substituting, these typical values into
equation (12), for the APC or c / y ratio we obtain
ct
= 0.72 (0.75 ) + 0.06 (3) = 0.54 + 0.18 = 0.72
yt

5
Ando-Modigliani noted that the observed data for the U.S. confirm that both these terms were fairly
constant. Overtime, the labour share of income has remained around 75 percent with a slight tendency to
drift up, and the ratio of assets to income has been roughly constant at about 3 percent with a slight
tendency to drift downward overtime.

12
 Thus, the average propensity to consume out of total income ( c / y ) is constant at about
0.72, which implies that the line OX in Figure 1.5 is a straight line passing through the
origin with the slope of 0.72.

Merits of the life-cycle hypothesis

1) The Ando-Modigliani model of consumption behavior
explains all three of the observed consumption phenomena. That is
(A) It explains the MPC < APC result of cross-section budget studies by the life-
cycle hypothesis.
(B) It provides an explanation for the cyclical behavior of consumption with the
consumption-income ratio inversely related to income along a short-run
function (see Figure 1.3) and
(C) It also explains the long-run constancy of the average propensity to consume out
of total income ( c / y ratio).

2) In addition, it explicitly includes assets as an explanatory

variable in the consumption function, a role which was observed in the post-World
War II inflation.

Limitations of the life-cycle hypothesis

1) There remains a question concerning the role of current income in explaining
current consumption whether

1.1.4 The Friedman approach: Permanent Income Hypothesis

Freidman also begins with the assumption of individual consumer utility maximization
which gives the relationship between an individual’s consumption and PV of future
streams of income. That is
c i = f i ( PV i ) --------------------------------------------------------- (1)

Where, the change in consumption with respect to or f ′ > 0 . Friedman differs from
Ando-Modigliani beginning with his treatment of the PV . Multiplying expression (1) by
the rate of return on assets ( r ) gives us Friedman’s permanent income.
y Pi = r ( PV i ) ---------------------------------------------------------- (2)

Where, y Pi and r are permanent income and interest rate respectively. Equation (2) is
the permanent income from the consumer present value, which includes his/her human
capita- the PV of his/her future labour income stream, that is included in PV in equation
(2) and his/her wealth ( α0 ).
y Pi = y 0i + α 0 ---------------------------------------------------------- (3)

Like Ando-Modigliani, Friedman also assumes that an individual consumer wants to

smooth his/her actual income stream into a more or less flat/uniform consumption

13
pattern. This assumption gives a level of individual’s permanent consumption ( c Pi ),
which is proportional to his/her permanent income ( y Pi ):
c Pi = k i ( y Pi ) ---------------------------------------------------------- (4)

The individual’s permanent consumption to permanent income ratio ( k i ) mainly

depends on the interest rate (r ) -the return on saving and individual tests (τ) shaping the
indifference curves, and the variability of expected income. That is,
c P = k (r ,τ ) y P ------------------------------------------------------- (5)

Thus, if there is no reason to expect these factors to be associated with the level of
income, we can assume that the average k i for all income classes will be the same;
−
equal to the population average k . If we classify the population by income strata, we
would expect that the average permanent consumption in each income class i (using
−
subscripts for income class as opposed superscripts to denote individuals) would be k
times the average permanent income.
− − −
c Pi = k ( y Pi ), for all income class i ------------------------------ (6)

Equation (6) states that permanent consumption of any income class (group) i , be it the
high or lower than average-income group, is a certain proportion of the group’s
permanent. According to Friedman, total income of an individual is composed of two
components: permanent income ( y Pi ), which the individual has imputed for himself,
plus a random transitory/random income ( yTi ), which can be positive, negative, or zero,
and really represents income deviations from permanent income. That is, measured
income is the sum of permanent and transitory income.
y i = y Pi + yTi -------------------------------------------------------- (7)

In equation (7) the subscript T refers to “transitory” not time. Permanent income is
therefore, that part of income which the household regards as normal or expected, while
transitory income is the difference between measured and permanent income, which
arises due to unexpected or unforeseen occurrences or chances (such as a win in lottery).
Similarly, total consumption in any period is the sum of permanent consumption ( c Pi )
and a random transitory-consumption6 component ( cTi ), which can be positive, negative,
or zero, and represents deviations from the “normal” or permanent level of consumption.
Thus, measured consumption is the sum of permanent and transitory consumption.
ci = c Pi + cTi ------------------------------------------------------- (8)

6
It is important to note that, at any period, transitory consumption can also be planned in advance or
unplanned at all. Whether planned or unplanned, random expenditures will be made only for a very short
period of time. Examples include expenditure on weeding, in case of condolence, hospitalization, inviting
a friend (s), etc.

14
In order to give the model some predictable power Friedman makes three further
assumptions concerning the relationship between permanent and transitory income,
permanent and transitory consumption, and transitory income and consumption. The
assumptions concerning these relationships give the explanation in the Friedman theory
of the cross-section result that MPC < APC .

First, Friedman assumes that there is no symmetric relationship or correlation between

permanent income and transitory income; in other words, yT is just a random
disturbance (fluctuation) around y P . So the covariance of y P and yT across
individuals; i.e., the Cov ( y Pi , yTi ) = 0

This assumption has the following implication for cross-section budget study results.
Suppose we draw a sample of families from a roughly normal income distribution and
then sort them out by income classes.
 Since y P and yT are not related, the income class that centers on the population
average income will have an average transitory-income component equal to zero
−
(i.e., yT = 0 ) and for that income class observed income will be equal to permanent
− −
income (or y = y P ).
 As we go up from the average income strata, we will find for each income class,
more people in that income group because they had unusually high incomes that
year, that is yTi > 0 than people who were in that class because they had unusually
low incomes that year. This happened because in a normal distribution, for any
income class above the average, there are more people with permanent income
below that class who can come up into it because yTi > 0 in any one period than
there are people above that class who can fall down due to yTi < 0 . Thus, for
−
income classes above the population mean transitory income is positive ( yT > 0 )
− −
and hence observed income will be greater than permanent income ( y > y P ).
 Similarly, below the average-income level, for any income class, there are more
people who can fall into it due to having bad year so that yTi < 0 than people who
come up to it by having good year so that yTi > 0 . Thus, for the population in the
below average- income class transitory income is negative ( yTi < 0 ). As a result,
− −
observed income will be less than permanent income ( y < y P ).

This result, that when sorted by measured income, groups above the population mean
− −
have yT > 0 and groups below the population mean have yT < 0 is important for
Friedman’s analysis, as we will see shortly.

15
Second, he assumes that there is no correlation or symmetric relationship between
permanent consumption and transitory consumption. In other word, cT is just a random
disturbance (fluctuation) around c P , which implies the Cov (c Pi , cTi ) = 0 .

Finally, he assumes that there is no symmetric relationship or correlation between

transitory consumption and transitory income. In other words, a sudden increase in
income due to transitory fluctuation will not contribute immediately to an individual’s
consumption. Thus, he concluded that the Cov ( yT , cT ) = 0 .

The last assumption is intuitively less obvious or is highly debatable than the previous
two, suggesting a lottery win does not increase transitory consumption. But it seems
fairly reasonable since we are dealing with consumption as opposed to consumer
expenditure. Freidman justifies this by arguing that in the face of a transitory rise in
income individuals usually stick to the consumption plan and just opt to increase their
savings. An alternative explanation is that his definition of consumption includes only the
flow of service from durable goods and not expenditure on durable goods. If transitory
income is spent on durable goods, then this can be classified as unplanned saving rather
than unplanned consumption. In this sense the assumption looks much more credible.

The last two assumptions, that transitory consumption is not correlated with either
permanent consumption or transitory income, mean that when we sample the population
and classify the sample by income levels, for each income class the transitory variation in
−
consumption will cancel out so that for each income class c Ti = 0 and average permanent
− −
consumption is the population average, c = c Pi ; for all income class i .

We can now bring this series assumptions together into an explanation of the cross-
section result that MPC < APC even when the basic hypothesis of the theory is that the
−
ratio of permanent consumption to permanent income is a constant k .

1.1.4.1 Cross-section consumption function

Consider a randomly selected sample of population classified by income levels. For
simplicity, let us denote income group i above and below the population average by
different letters as the above average population income group by H and the below
average population income group by B . On the other hand, the average population
income refers to national income/output divided by total population, which is most
popularly known as the Per Capita Income (PCI). In figure 1.6 it is designated by
− −
y = y P in the horizontal axis.

−
A group H with average observed income y H above the average population income will
−
have a positive average transitory-income component y TH . Then for this above-average

16
group, observed average income will be greater than average permanent income; that is
− −
y H > y PH (see to the right of the mid point of the horizontal axis in Figure 1.6).

Observe that average consumption, both measured and permanent for group i is given
−
by multiplying permanent income by k to obtain permanent consumption along the
solid line in figure 1.7. That is, first all income groups will have average permanent
− − − − − −
consumption equal to k y Pi (or c Pi = k y Pi ) along the k line. Since transitory
−
consumption of income group i ( c Ti ) is not related to either to its permanent
− −
consumption ( c Pi ) or transitory income ( y Ti ); by assumption 1, all groups, including
the above-average income group will have zero average transitory-consumption
−
component. Moreover, measured average consumption of income group i (i.e., c i ) is
− − −
equal to its permanent consumption ( c Pi ) or c i = c Pi . Linking these two consumption
conditions gives us
− − − −
c i = c Pi = k y Pi ----------------------------------------------------- (8)

− −
− ci c Pi
From equation (8), we know that k = = −
− − . The solid line k represents the
y Pi y Pi
−
relationship between permanent consumption and permanent income. The point y is the
population average measured income and if the sample is taken in “normal” year when
−
measured average income is on trend or along k line, then average transitory income
− −
will be zero; so that measured average and permanent income will be equal (i.e., y = y P
− −
). On the other hand, the point c = c P is the population average measured consumption
and permanent consumption.

However, though the above-average income group have average measured consumption (
− − −
c H ) equal to permanent consumption ( c PH ), its average measured income ( y H ) is
−
greater than permanent income ( y PH ) as shown by point A . As a result, an above-
− −
average income group’s measured consumption to income ratio ( c H / y H ) will be less
− −
− ci c Pi
than k = −
= − . A similar story follows for the below-average income group ( B ).
y Pi y Pi
For this group, the average observed income is below average population income as

17
 − − − −
shown by point B and hence measured consumption to income ratio ( c B / y B or c PB / y B
−
) is greater than k . These results are illustrated in Figure 1.6.

First, consider sample group H with average income above the population average
− − −
(i.e., y H > y ). This group has positive average transitory income component ( y TH ),
− −
which is greater than the population average permanent income (i.e., y TH > y P ), as
shown in the horizontal axis of Figure 1.6. Nevertheless, neither measured consumption
nor the permanent consumption of the above average income group does not increase
− −
proportional to the increase in transitory income; so that c H = c PH in the upper part of
the vertical axis. In order to locate both the measured and permanent average
− −
consumption for group H we multiply permanent income ( y PH ) by k to obtain
− − −
c H = c PH along the k line. Thus, for an above-average income group ( H ) we observe
− − −
c H and y H ate at point A , which lies below the permanent consumption line k .

c(cons n)
−
−
k

− −
c H = c PH A

− −
c = cP
−
y TH > 0
− −
c B = c PB B

− − − − − − −
y TB < 0 yB y PB y = yP y PH yH y (Income )

Figure 1.6: Friedman’s permanent income hypothesis consumption function

Next, observing lower than-average income group ( B ), we see in the horizontal axis that
− −
the average income of the group ( y B ) is less than the national average income ( y ) or

18
− −
y B < y . This is because, the average transitory income of the below-average sample
− −
group ( y TB ) is less than zero. Nevertheless, average observed consumption (i.e., c B )
does not decrease from that of the permanent consumption of B' s income group.
− − − −
Furthermore, we observe that c B and know that it is equal to c PB and k y PB or
− − − − − − −
c J = c PJ = k y PJ along the k line. The location of c B and y B gives us point B , lying
−
above the k line.

Therefore, connecting the points A and B, we obtain the cross-section consumption

function that connects observed average income-consumption points. Since, this function
has smaller slope than the underlying permanent function, it implies that in the cross-
section budget studies we expect to see that marginal propensity to consume ( MPC ) is
less than average propensity to consume ( APC ) or MPC < APC if (but only if) the
Friedman permanent hypothesis is correct (holds).

1.1.4.2. Time series data

The permanent income hypothesis can also be used to explain the time series data. In
−
Figure 1.7, the long run permanent consumption function is again given by k . Overtime,
as the economy and the national average permanent income grows along trend. What we
observe in a long-run time series data are thus movements of the national average
−
consumption and income along the line k ; giving a constant c / y ratio. As the economy
− −
cycles along its trend growth path, the average c/ y point will move above and below
− −
the long-run line k . During boom year, say period 1, when y t is above the trend, the
average transitory income of the population will be positive as measured by the distance
− − − −
y 1 − y P1 and hence average income will be greater than permanent income (or y 1 > y P1 ).
− − − − −
But average transitory consumption will be zero; implying c = c P = k y P . Thus, when y
− − − −
is above trend, c 1 / y 1 will be less than c P1 / y P1 = k .

− −
Similarly, in times of economic slump or when y t is below the trend as in year 2, y 2
− − − − −
will be negative; y 2 < y P 2 ; and the c 2 / y 2 ratio will be greater than k . The cyclical
movement is depicted in Figure 1.7. Again joining point A and B gives the short-run
time-series consumption function, where again the short run MPC is less than the long
run MPC and MPC < APC , but in the long-run MPC = APC .

19
Note that the difference between figure 1.6 and 1.7 is that in figure 1.6 the variation in
income and consumption is in a cross-section in any one time, while in figure 1.7 the
variation is in average income and consumption over the business cycle.
−
c k

SR Consumption functions
−
c1 A

−
c0
−
c2 B

− −
yT 2 y T1

− − − − −
y 2 y P 2 y 0 y P1 y 1 y
Figure 1.7: Friedman’s consumption function: cyclical movements

2.2.3 Distinguishing features of the lifecycle and permanent income hypotheses

Similarities
I. The two models are similar in the starting point of the analysis in the
consumption-present value relationship given in equation 2.1. In other words,
both hypotheses have micro foundation. Thus, they argued that an individual have
different income stream of income in life and smooth out consumption overtime
II. Both concentrate on the structural relationship between expected lifetime income
and current consumption.
III. Both the LCH and PIH treated the wealth effect on consumption.

Differences: The two theories differ in the empirical implementation of the theory
I. The LCH model exhibit smaller MPC than PIH because the former also includes a
wealth variable whereas in the latter the wealth effect is included in permanent
income.
II. Friedman’s consumption model/function is somewhat less satisfactory than
Modigliani in that assets are only implicitly taken into account as determinants of
permanent income. In short, he did not clearly distinguishes between permanent
income (YP ) and α0 (which is considered as a shift factor) as did by Ando-
Modigliani , and

20
 III. Friedman relies on the unobservable concepts of income (i.e., permanent income
and transitory incomes) while Ando-Modigliani relies on the observable income
(i.e., income from labour and income from assets/property or the value of assets)

Applicability of the consumption theories to LDCs

How consumption theories discussed so far are relevant to LDCs such as a typical
African economy?
1) Both the LCH and PIH emphasize on households consumption smoothing or have
uniform consumption pattern (intertemporal consumption) due to their assumption of
absence of borrowing and lending (liquidity) constraints to households. However,
these assumptions are unrealistic in explaining the actual situation of African
economies where households have excessive borrowing and lending constraints.

This is because we know that financial sectors are underdeveloped in almost all African
economies. Due to this the majority of households do not have easy access to financial
sectors. As a result, households in Africa, particularly those living in rural areas, are
forced to relay mostly on individual creditors or usurers for borrowing. Even when there
are financial intermediaries they have acute shortage of loanable fund due to high
propensity to consume /or low propensity to save/ by the population due to high
dependency ratio and in part due to commercial banks weak capacity to mobilize savings.
Moreover, protracted loan application screening and disbursement processes; high
collateral requirements of banks than most households can afford; and high lending
interest rates are also some of the major constraints. For instance lending rate of
commercial banks in Ethiopia is greater than 10% compared to only 1.5% in England.

In some cases, there are preferential treatments of financial intermediaries to public

sectors borrowing than private firms and/or individuals in LDCs. This biased policy can
be either due to political reasons; credit ceilings; or poor loan repayment enforcement
mechanism to defaulters. The later has to do mostly with the underdevelopment of legal
and judiciary system in LDCs.

2) The notion of the present value of future income streams in both the LCH and PIH
models implies that consumers or economic agents have long planning horizon.
Nevertheless, this assumption is irrelevant for a typical LDC even though there is no
borrowing and lending constraints.

The reason is that, the planning horizon in LDCs is different than developed countries
due to uncertainty in terms of what will happen next, which in turn influence peoples’
preferences for investment (which is more of short term than long term planning
horizon); perception of life, and control over assets.

3) Parallel to the second limitation of the models, the assumption of perfect capital
markets in both the LCH and PIH and hence income from assets at any time is equal
to the value of asset itself are also irrelevant to LDCs or African economies. This is
because markets in LDCs are more of imperfect and hence getting information about
the value of assets is costly.

21
 4) The argument of the LCH that individuals will save when income is high during
adult for retirement does not also explain much LDC economies that have different
demographic structure compared to developed countries. This is because LDCs have
more young population, large family size, and high population growth7 compared to
developed countries due to high birth rate.

High population growth and the type and composition of family in LDCs (extended
family compared to nuclear family in developed countries) have in turn lead to high
dependency ratio. Thus if resources are shared between workers and the dependents, the
need for hump or saving when adult for retirement as the LCH argued is not necessary.

5) Income derived from agriculture is not considered explicitly in the models.

In a typical African household economy, there is high uncertainty of income due to the
erratic behavior of agricultural output or its vulnerability to weather change and
macroeconomic instabilities such as fluctuation of price and exchange rate fueled by
internal and external shocks. Hence, the subsistence income level derived from
agriculture possesses a real threat to consumption level of households, a threat that is
likely to exert powerful influence on the way in which income is spend and saved. Thus,
in such a context the standard model in which permanent consumption is equal to
permanent income cannot be derived from the utility maximization of an individual.

In general, the implication of the above limitations of the models is that ct < y t + α t in
L

most LDCs. Therefore, the direct applicability of the models in explaining the subsistence
economy of a typical LDCs or African economies is less compared to that of developed
countries.

Exercise 1.1:
1) Distinguish between consumption of durable goods and consumer purchase of durable
goods. Why is this distinction important?
2) Use the two period intertemporal model of consumption to show the effect of the
following
(A) an decrease in income in period 1
(B) supposing an individual faces a borrowing constraint in period zero and period 1
3) In the context of the permanent income hypothesis what happen to consumption when
(A) There is charismas bonus
(B) There is temporary tax increase
(C) There is a major house repair required
4) Assume that you have established an empirical consumption function of
ct = 0.40 y t + 0.20 y t −1 + 0.006 αt
Where, ct , y t , and αt are real consumption, real income, and real wealth. What would
you estimate to be
(A) The short-run MPC?
7
For instance the average size and population growth in Ethiopia are 6 and 2.5% respectively. With this
growth rate, the WB (2004) has forecasted that Ethiopia will be the 9th populated country in the world by
the year 2050.

22
 (B) The long run MPC?
(C) The short run APC?

1.2 INVESTMENT DEMAND HYPOTHESES

Investment is the accumulation of physical capital by firms’ overtime. There are three
different types of real capital goods: fixed capital, items such as plant, machinery, and
building; working capital, which consists of stock of raw materials, manufactured input,
and final goods awaiting for sale; and residual investment, which include new houses for
purchase or rent. Of these components of investment, fixed capital is the most important
and is commonly referred as gross domestic capital formation.

Investment is much smaller than consumption, but it is the most volatile component of
aggregate demand. Despite its size, investment is very important for the macro economy,
since it is by investing in plant and machinery that the economy can produce goods for
consumption in the future. Thus investment is an inherently dynamic process, whereby
consumption is sacrificed today in order to enhance production and consumption in the
future. Investment is therefore an element of economic growth.

From a theoretical point of view a stationary economy one where the capital stock is
constant and the level of investment is exactly equal to the rate of depreciation of the
existing capital stock. So although existing machineries are replaced as they wear out,
there are no new additions to the capital stock, thus net investment, i N is zero. In this
case, total or gross investment, iG is exactly equal to replacement investment- i R . This
can be represented by a simple identity
iG = i N + i R --------------------------------------------------- (1)
In the following sections four principal alternative theories of investment will be
considered: Keynes theory of investment; the neoclassical theory of investment; the
accelerator theory; and the Tobin’s Q model of investment.

1.2.1 Keynesian Explanation of investment

There are two distinctive components in the Keynes’ theory of investment. First, he
emphasizes on the role of expectations in deriving investment demand and second, he
explicitly refers to the supply of capital goods which is related to the marginal efficiency
of capital (MEC). In modern project analysis, the two components of Keynes’ theory of
investment are called discounting measures of project worth or investment
assessment criteria

1.2.1.1 Net Present Value (NPV)

For Keynes the value of the owners unit of capital equipment was the flow of income, y j
it would yield over its life in excess of the purchase cost. The flow can be thought as the
net present value of income (NPV) or the demand price, V D , of the machine. Thus, the
discounted net lifetime income of the machine is given as:
y1 y2 yj N
 yt + j 
NPV = y 0 +
(1 + r ) 1
+
(1 + r ) 2
+ ... +
(1 + r ) j
= ∑   = Vt D --- (2)
j 
j =0  (1 + r ) 

23
Where, r is the rate of interest and N is the life of the asset. Thus, if NPV or the
demand price is greater than zero the investment project is profitable, in that the expected
future revenue exceeds cost. As progressively more marginal projects are added the
demand price of new capital declines until NPV becomes equal to zero, after which the
additional project yields negative returns (profit).
D
V

D K (r )

0 K
Figure 1.8: The demand price of capital

Figure 1.9 shows that the demand schedule for capital good, which rises as the demand
price falls, for a given market rate of interest and stream of expected returns.

A project’s net benefits have to be measured against the benefits that could have been
gained by investing the equivalent sum for alternative uses. This is termed as the
opportunity cost of capital achieved by using Discounted Cash Flow (DCF) measures of
project worth. In investment project analysis discounting is normally used to work out the
Present Value (PV) of a set of several Future Values (FVs). In its simplest form
equation (2) can be expressed as:
 1 
NPV = FV  t  --------------------------------------------------------------- (3)
 (1 + r ) 
Where, r is the discounted rate expressed as a fraction or percentage and t is year. The
value in the bracket is called discounted factor (DF) for each year.

The NPV is defined as the difference between the present values of the future benefits
and costs. It is the simplest of all the four methods and is essentially a measure of the
present value of aggregate surplus generated by the project over its expected operating
life. It is calculated by subtracting the present values of costs (PVC)8 from the present
values of benefits (PVB). This implies that NPV represents the net benefit over and
above the compensation for time and risk. This involves two steps of calculations as
expressed by the formula.
N N
NPV = ∑ PVB − ∑ PVC --------------------------------------------------- (3a)
t =0 t =0
Or
N
Bt N
Ct
NPV = ∑ − ∑ t --------------------------------------------- (3b)
t =0 (1 + r ) t =0 (1 + r )
t

Where, N is the life of a project

8
Total cost is the sum of investment costs, incremental working capital (incremental stocks plus net
incremental receivables, account receivable less account payable), and operating cost.

24
Decision Rule:
a. Accept the project if the NPV is positive, which implies that the net
benefits will be created after allowing for the required rate of return fixed principally
to cover the cost of capital in financing or opportunity cost of a sacrificed
investment.
b. If the NPV is zero, is a marginal case and hence the decision may need to be
informed by other criteria particularly for public sector projects. NPV equal to zero
means the project will return the capital utilized, but it will not generate any surplus.
c. Reject the project if the NPV is less than zero or negative because the
project will not recover its cost at the specified rate of discount.

1.2.1.2 Marginal efficiency of capital (MEC) or Internal Rate of Return (IRR)

In addition to the concept of the demand price of capital goods Keynes also introduced
the concept of the marginal efficiency of capital (MEC). The marginal efficiency of
capital is defined as the rate of discount, m , which would make the present value of
expected returns from the capital asset during the project life to just equal to zero or the
supply price, V S ; that is;
N
 yt 
∑   = Vt S = 0 ------------------------------------------------ (4)
t 
j =0  (1 + m) 

Where, m is the supply price of capital asset, which would just induce a manufacturer to
produce new additional unit of such assets. That is the supply price is the replacement
cost of new machine and not the cost of the purchase of second-hand machine, which of
course does not add to the stock of capital in the economy as a whole. Thus the MEC or
m , is drawn for a given capital stream of expected returns and the supply price of
capital. Indeed if m > r , new capital equipment would be profitable to acquire, since only
then will the MEC exceed the market interest rate, which denotes the return on alternative
asses. In equilibrium, Keynes argued that the MEC in general is equal to the rate of
interest; that is m = r .

In sum the PV ranking depends on the market interest rate-the rate at which earning can
be reinvested-while the MEC of investment is not related to the market rate. So the PV
rankings can be different from m rankings. The best way to see this is to look at an
example which can be easily generalized.

Example 1: Suppose we have two investment projects, both with initial cost one million.
Both projects have zero return in period/year 1, when they are built. Project I returns 0 in
period 1, and 4 in period 2. Project II on the other hand, returns 2 million in period 1 and
1 million in period 2. The costs and returns of two projects are summarized in the table
below.

Year Project I Project II

Cost Return Cost Return
0 1 0 1 0
1 0 2

25
 2 4 1

Given the information given in the table above

1) Calculate the NPV of the two projects at market interest rate equal to 5% and 10%
2) In which project should an investor invest when market interest rate are 5% and
10%? Why?
3) If financial constraint dictates the investor to invest in one of the projects which
one should be chosen at the lowest interest rate? Why?
4) Calculate the MEC ( m ) for the two projects
5) If the two projects are competing which of the two projects is better according to
the MEC criterion? Why?
6) If the projects are not competing should we select and invest in both projects
according to the MEC criterion? Why or why not?

SOLUTION:
1) The NPV of the two projects at interest rate equal to 5% and 10%. To
calculate the NPV we follow the following three steps

First: Find the net benefit of the two projects by subtracting the return of the projects
in each year. The net benefits of project I and II are shown in column 2 and 3
respectively.
Second: Find the discount factor at 5% and 10% from year zero to year two. This can
1 1
be obtained by using the formula; , ,... .It is shown in the 3rd and 4th
(1 = r ) (1 + r )1
0

column in the table below.

Third: Multiply the net benefit of project I and II in each year by the corresponding
discount factors to get the NPV of the projects in each year. Summing up the NPV of
the projects in each year gives the overall NPV as shown from column 6 to column 9.

Table 1.1: Net Present Value (NPV) and Marginal efficiency of capital (MEC)
Net benefit (Return – Cost) Discount Factors NPV Project I NPV Project II
1.Year 2.Project I 3.Project II 4.r=0% 5. r=1% 6.(1*3) 7.(1*4) 8.(2*3) 9.(2*4)
0 -1 -1 1 1 -1 -1 -1 -1
1 0 2 0.9524 0.9091 0 0 1.9048 1.8182
2 4 1 0.9070 0.8264 3.625 3.3056 0.9070 0.8264
SUM 0.9804 0.9612 2.6281 2.3056 1.8118 1.6446

2) Based on the overall NPV of the two projects as shown in the last row of
column 6 to column 9 an investor should invest in both projects. This is because
the overall NPV of the projects at 5% and 10% are greater than zero. However, the
NPV of both projects is higher at 5% than at 10%.
3) If an investor has financial constraint to invest in the two projects, he/she
should decide to invest in project II than in project I both at 5% and 10% market
interest rate for it yields higher NPV; that is as can be seen in the last row of table
1.1 above 2.6281 is greater than 1.8118 when the market interest rate is 5% and
2.3058 is greater than 1.6446 at 10%. However, not that if the NPV of projects
vary as the market interest rate changes the criterion does not help to make such a

26
 conclusion. The reason is that if we compare two projects, the one which has
larger return in the distant future (e.g. project I in year 2) will have higher NPV at
some low interest rate than the second project that yields smaller return in future
(e.g. in year 2) and will have a higher NPV at some higher market interest rate that
pushes down the PV of the distant returns of the first project. For instance,
calculate and determine which project is better according to the NPV criterion
when market interest rate is zero and 100%.
4) The marginal efficiency of capital (MEC) or IRR using the NPV formula
but looking for the interest rate that makes the NPV equal to zero for each
projects.

MEC of Project 1:
0 0 4
MEC 1 = −1 + + + =0
(1 + m) 0
(1 + m) 1
(1 + m) 2
4
1=
(1 + m) 2
Solving this equation for m , we have
(1 + m) 2 = 4
1+m = 4 = 2
m = 2 − 1 = 1 . This implies that the NPV of project
I will be equal to zero when the rate of discount, m ,is 100%.

MEC of Project 2:
0 2 1
MEC 2 = −1 + + + =0
(1 + m) 0 (1 + m)1 (1 + m) 2
Moving −1 to the other side of the equation and multiplying both sides by (1 + m) 2
gives
 2 1 
(1 + m) 2 =  + 2 
(1 + m) 2
 (1 + m ) 1
(1 + m ) 
(1 + m) 2 = 2(1 + m) +1
(1 + m) 2 = 2 + 2m +1 . Factorizing the left hand side we get
1 + 2m + m 2 = 2 + 2m + 1 . Subtracting 1 + 2m from both sides we have
m2 = 2
m= . This implies that the rate of discount ( m ) that
2 = 1.414
makes the NPV of the second project zero is 141.4%.

Thus, since the MEC of the two projects is greater than the market interest rate both
investment projects should be chosen. The MEC investment criterion or IRR indicates
that project II is unequivocally better than project I, because m2 > m1 or 1.414 > 1 . The
implication is that project I will have higher NPV at market interest rate lower than the
equilibrium interest rate that makes the NPV of the two projects equal and the NPV of
project II will be at higher at interest rate higher than the equilibrium rate.

27
In reference to this conclusion someone may raise the following questions. What is
equilibrium interest rate that makes the NPV of the two projects equal? How can we
calculate it? How can we show it graphically? We follow the steps below to answer these
questions for projects with two years life.

First: Find the NPV of the two projects when interest rate is zero. Following the same
procedure in example 1, we will get the NPV of project I equal to 3 and that of project II
is 2 when the market interest rate is zero or there is no market interest rate to be charged
on funds obtained from borrowing.
Second: Find the equilibrium interest rate that makes the NPV of the two projects equal.
This can be determined by equating the NPV of the two projects as
NPV 1 = NPV 2
0 4 2 1
−1 + + = −1 + + . Dropping −1 from both sides
(1 + r ) 1
(1 + r ) 2
(1 + r ) 1
(1 + r ) 2
and multiplying through by (1 + r ) 2 gives us
4 = 2r + 2 + 1
r = 1 / 2 = 0.5 . This implies that the NPV of the two projects will be equal when
interest rate is 50%. In short, the equilibrium interest rate is half of the lower discount
rate; that is 1 / 2(m1 ) .

At r = 0.5 or 50% the NPV of both projects is 0.78. You can verify this using the NPV
criterion we have applied in example 1 while computing the NPV of the projects at 5%
and 10%. Therefore, if the two projects are competing the investor should choose project
I if the market interest rate is below 50% and project II if the market interest rate is above
50%.

Third: We depict the NPV of the projects in the first and second steps as well as at the
rate of discount ( m ) graphically as follows.
PV

3.0

2.0

1.0
0.78 E

0.2 0.4 0.6 0.8 1 1.4 II 2 r

I
Figure 1.9: Present value and the market interest

Decision rule for MEC:

28
 • Accept the project if the MEC or IRR is greater than the market interest rate.
For competing projects choose the one with the higher IRR.
• If MEC or IRR is equal to the market interest rate, it indicates the project has
no net return but will recover the cost to be incurred. In other word the project is
marginal.
• Reject the project with MEC or IRR less than the market interest rate because it will
not recover its cost after allowing for the cost of capital.

Exercise 1.2: Given information on the costs and returns for investment project X and Y
answer the following questions.
1) Find the sum of the net benefit streams of the projects and discus the implication
2) Calculate the NPV of the two projects at the market interest rate of 5%. Which of
the two investment project is better according to the NPV criterion? Why?
3) Calculate the MEC of the projects. Which one is better according to the MEC?
Why?
4) What is the equilibrium market interest rate? What will be the NPV of the projects
at that interest rate? In witch should we invest if market interest rate is below the
equilibrium rate?
 Evaluation of NPV:
The NPV as one of the discounting criteria of measuring project worth has the following
advantages.
a. It takes into account the value of resources overtime.
b. It considers the net benefit stream in its entirety.
c. The NPV of various projects, measured as they are in
today’s Birr can be added. The additive property of NPV ensures that a poor project
(one which has a negative NPV) will not be accepted, just because it is combined
with a good project, which has positive NPV.
d. The concept is clear and the solution is always
determined.

Despite the above advantages, the NPV has its opponents towards some limitations.
a. The application and dimension of NPV, seems to be
constrained in ranking investment or projects, is influenced by the discount rate.
b. The NPV is expressed by in absolute terms rather
than relative terms and hence does not factor in the scale of investment. For
example, project A may have a NPV of 5000 while project B has a NPV of 2500, but
project A requires an investment of Birr 50,000 whereas project B may require an
investment of 10,000. Advocators of NPV argue that what matters is the surplus
value (rate of returns) irrespective of what is invested. However, opponents argue
that for the NPV is an absolute measure of value it does not show the efficiency of a
project in using capital. Out of the two projects B is efficient than A for its
investment capital generates a 25% return than as compared to 10% of A.
c. The NPV rule does not consider the life of the
project. Hence, when mutually exclusive projects are with different lives are
considered the NPV is rule is biased in favour of the longer-term projects.

29
  Evaluation of MEC or IRR:
The use of MEC or IRR as a measure of project worth has the following advantages.
a. It is more familiar concept and better understood by most
people
b. It takes into account the value of resources overtime.
c. It considers the net benefit stream in its entirety.
d. It provides a measure of efficiency of the project in using
capital.
The limitations of MEC or IRR include:
a. Table 1.1 illustrates on of the deficiency of the MEC for ranking
investment projects. That is the MEC criterion makes no reference to the market
interest rate, which measures the opportunity cost of capital.
b. It does not distinguish between large and small investment and it does
not tell anything about the timing of the net benefits of the project. Therefore, it is not
very useful for deciding between two or more mutually exclusive projects.
c. It is also possible that if the net benefit stream of a project changes or
has more than one sign, there may be more than one IRR.

Exercise 1.3:
(1) Calculate the NPV for the hypothetical X and Y projects at
10%. The cost and benefit streams are given in the table below (All figures in
million)
Year 1.Total 2.Total
cost Revenues/Benefits
0 140 0.0
1 65 100
2 95 150
3 95 200
4 75 150
5 55 100

(2) Given the cash flow for 2 projects calculate the NPV of the
two projects at 10% interest rate
Yea Project 1 Cash Project 2
r flow Cash flow
0 (1,000,000) (1,000,000)
1 65,000 35,000
2 55,000 45,000
3 45,000 55,000
4 35,000 65,000

1.2.2 The Flexible Accelerator (inventory) model

The relationship between the growth rate of output and the level of net investment implied
in the previous section is called the accelerator principle since it suggests that an increase
in the growth rate of output or acceleration is needed to increase the level of investment.
The PV criterion suggests that this relationship between output growth and net
investment is not a fixed one. However, an increase in interest rate should reduce the

30
level of net investment associated with a given growth rate of output. This variable
relationship between the growth rate of output and the level of net investment is
frequently known as the flexible accelerator model.

Equilibrium capital stock: we begin with the general production function

∂y ∂y
y = f ( L, K ) ; , > 0 ------------------------------------------- (2.1)
∂L ∂K

Here, y is output pre unit of time; L is human power input per unit of time; and K is the
capital stock.-plant and equipment. Implicitly we assume here a constant rate of
utilization of capital stock so that there is a one-to-one relationship between capital stock
and machine hour input. Thus a firm will expand its plan size until the marginal product
of capita equals the real user cost of capital.
∂y C
= ≡ c ----------------------------------------------------------- (2.2)
∂K P

Where, c is the real user cost of capital. Equation (2.2) can be seen in another way. The
increase in revenue which a competitive firm will obtain by adding another unit of capital
, given its labour input is price of output times the increment to output produced by the
increase in K .
∆R ∂y
= P.
∆K ∂K

The increased cost to the firm of adding another unit of capital is simply the user cost of
that unit
∆C
=c
∆K
As long as the increase in revenue is greater than the increase in cost from another unit of
capital the competitive firm will add capital. Equilibrium will be reached when
∆R ∆C ∂y
= and P. = c , which is the same condition as equation
∆K ∆K ∂K
(2.2).

This marginal condition (2.2) determines the equilibrium capital stock of the firm. Let’s
take the following Cobb-Douglas production function as an example.
β
y = aK L1−β

This production function has the property that the exponent of the capital and labour
inputs add up to one, which gives constant return to scale. If capital and labour inputs are
doubled, output will also double. The marginal product of capital in the Cobb-Douglas
function is given by
∂y
= βaK β −1
L1−β --------------------------------------------------- (2.3)
∂K

This can also be written as

31
 ∂y βaK β L1−β βy
= = , substituting y back into aK β
L1−β .
∂K K K

Thus with the Cobb-Douglas function, in equilibrium

∂y βy C
= = ----------------------------------------------------- (2.4)
∂K K P

The right hand side of equation (2.4) can be solved for the equilibrium level of capital
stock in the Cobb-Douglas function

βPy βy
KE = =
C C -------------------------------------------------- (2.5)
P
The equilibrium capital stock rises with an increase in y and falls with an increase in the
real user cost of capital. Equation (2.5) gives the expression for a particular production
function. We can generalize this by writing K E as a function of y , C , and P .
K E = K E ( y, C , P ) ------------------------------------------------ (2.6)

In equation (2.6), ∂K E / ∂y and ∂K E / ∂P are positive and ∂K E / ∂C is negative. With

equation (2.6) as a general expression for the determinants of K E , we can now develop
the investment demand function relating realized investment to K E .

Investment demand and output growth: Total or gross investment is given as the sum
of net investment ( i N ) and replacement investment ( i R ).
iG = i N + i R ------------------------------------------------------- (2.7)

Net investment is that part of gross investment that increases the level of capital stock.
On the other hand, replacement investment is part of gross investment needed to keep the
capital stock at a constant level and is equal to economic depreciation of the stock in any
one period. Replacement investment will simply be the depreciation of the capital stock
(δK )
i R = δK ----------------------------------------------------------- (2.8)

Where, δ is the depreciation rate; a number like one-tenth for building and one-fifth for
vehicles. Net investment in the absence of lags in the adjustment process of actual capital
stock to desired capital stock, would be
i N = ∆K E --------------------------------------------------------- (2.9)

Thus we can see that net investment depends on changes in equilibrium level of capital
stock, whereas replacement investment depends on the level of capital stock.

Looking at net investment first using the Cobb-Douglas function gives

 βPy 
i N = ∆K E = ∆  -------------------------------------------- (2.10a)
 C 

32
If we assume that the ratio of user cost of capital to the price level, ceteris paribus,
remains fairly constant overtime, we can rewrite equation (2.10a) as
 βP 
iN =  ∆y ---------------------------------------------------- (2.10b)
 C 

This makes it clear that over the long run, with no trend in C / P , it is the growth of
output or demand that gives us the level of net investment. The relationship between the
change in output and the level of investment is the flexible accelerator model that
introduced a basic dynamic relationship into the model of the economy. Thus, if net
investment is related to ∆y by equation (2.10b) and net investment is also some fraction-
the net saving ratio (s ) -of y ; that is
i N = sy

Then we have the basic growth relationship

 βP 
sy =  ∆y ----------------------------------------------------- (2.11)
 C 

Dividing both sides of equation (2.11) by y and solving for the growth rate of y ,
y  βP  ∆y
s = 
y  C  y
 βP  ∆y C
s =  , dividing both sides by βP , we have
 C  y
sC s
∆y = =
=Growth rate of y βP βP ----------------------------------- (2.12)
y
C

Since investment increases the supply of output by increasing the capital stock, but it is
also associated with the level of demand through the multiplier, equation (2.12) gives the
rate of growth of output that would maintain supply equal to demand.

Second let’s look at total investment using the concept of net and replacement investment
we have developed. Ignoring for a moment the lagged adjustment of actual to desired, we
have from equation (2.7), (2.8), and (2.9) that
iG = i N + i R = ∆K E + δK ----------------------------------------- (2.13)

In the general case, we can write the investment equation (using equation 2.6)
iG = ∆K E ( y , C , P ) + δK ----------------------------------------- (2.14)

In the Cobb-Douglas example, iG is given by

 βPy 
iG = ∆  + δK ----------------------------------------------- (2.15)
 C 

And in the special case where the real user cost of capital, c is fairly constant we have

33
 β
iG = ∆y + δK --------------------------------------------------- (2.16)
c
as the accelerator relationship.

The accelerator and stabilization policy: The accelerator relationship in the gross
investment function, equation (2.14) poses an interesting difficulty in the short-run
stabilization policy. This is shown in figure 1.10. The Figure shows what happens to
investment as output rises from one stable level in two time period, 0 to t1 and t 2 on
and a transition period of unspecified length between the two.

Real

k , y, i
KE
t2
∆K = ∑ i N
t1

K
y

iG
iR
iN

0 t1 t2 t

Figure 1.10: The “accelerator principle” on investment

In the first period there is a given level of output, y , which implies a given equilibrium
capital stock K .At time t1 , the government increases government purchases g to
stimulate demand and output and equilibrium capital stock move to new higher levels in
the second period, from t 2 on. Since the capital stock is constant both before t1 and after
t 2 , the level of investment is zero in each period and the level of i R is positive in each.

In order for the capital stock to increase to its new higher level in the second period, there
must be a positive level of net investment in the transition period. This is indicated by the
bulge in i N between t1 and t 2 . Since iG is the sum of i N and i R , this means that
during the transition period gross investment has also this bulge as shown by the dashed
line in figure 1.10. Thus, total or gross investment in each period is summarized as
follows
From 0 to t1 : iG = i R
From t1 to t 2 : iG = i R + i N

34
 From t 2 on: iG = i R

1.2.3 The neoclassical model of investment

This investment theory assumes:
1. A firm is a forward looking; that is it cares about the future stream of income
not only the present
2. The firm operates under perfect competitive; that is it is a price taker
3. There is no uncertainty about profit; there is no difference between expected
and actual profit. With these assumptions
1
PV 0 = ∑ ( Pt y t − wt Lt − Pt I it ) -------------------------------------- (3.1)
(1 + r ) t

The above profit maximization is subject to two constraints: technological constraints

and capital stock. Assuming CRS, we write the first constraint as
y t = y ( Lt , K t ) ------------------------------------------------------------------- (3.2)

Where, Lt is workers hour of input and K t capital stock - plants and equipments.
Besides, MPL =∂y ∂L >0; and MPK = ∂y ∂K > 0

The second constraint, which is capital stock, is written as

K t +1 = K t + it − δK t ------------------------------------------------------- (3.3)

Where, K t +1 is capital stock in the next period. Whereas K t and it refer to capital stock
available and additional investment in period t .On the other hand, δK t is the
depreciation or obsolete of capital stock in the production process. Constraint (3.2)
implies investment is a flow and capital is a stock. Thus, K t +1 is determined by the
difference between it −δK t .

The profit maximization equation is thus

∞
1
Max  = ∑ ( Pt y t − wt Lt − Pt I it ) + ∑λt [it + (1 − δ ) K t − K t +1 ] ------------ (3.4)
t =0 (1 + r ) t

However, based on the first constraint we know that Pt y t can be expressed as

Pt ( Lt , K t ) . Thus, equation (3.4) can be written as
∞
1
Max  = ∑ ( Pt ( Lt , K t ) − wt Lt − Pt I it ) + ∑λt [it + (1 − δ ) K t − K t +1 ] -------
t =0 (1 + r ) t

(3.5)

The question we want to address is that what will the optimum amount of labour to hired
( Lt ); capital stock/goods to employ ( K t ); and additional investment ( it ) to make in
order to maximize profit or equation (3.5). These can be achieved by the first order
derivative of equation (5) with respect to our variable of interest. That is

35
 ∂ 1  ∂y t 
=  Pt − wt  = 0 ---------------------------------------------- (3.6a)
∂Lt (1 + r ) t  ∂Lt 

This refers to the demand for labour. Rearranging (3.6a) gives us MPL is equal to real
∂y t
wage. That is = wt
∂Lt
∂ 1  ∂y t 
=  Pt  + λt (1 − δ ) − λt −1 = 0 -------------------------------- (3.6b)
∂K t (1 + r ) t  ∂K t 

Where, λt −1 refers that whatever capital stock that will be available next period is
dependent on what some one has this year. This comes because K t is the end of period
capital stock for K t −1 .
∂ 1
=− Pt I + λt = 0 --------------------------------------------------------- (3.6c)
∂it (1 + r ) t

∂
= it − (1 + δ ) K t − K t +1 = 0 ----------------------------------------------------- (3.6d)
∂λt

What is the profit maximizing capital stock? Rearranging (3.6c) gives us:
1 1
λt = Pt I . This implies that λt −1 = I
Pt − 1
(1 + r) t (1 + r ) t −1

Substituting these two into (3.6b) for λt and λt −1 we will obtain the users cost of capital.
∂ 1  ∂y t  1 1
= P
t  t + Pt I (1 − δ ) − t −1
Pt −I 1 = 0 --------------- (3.6c1)
∂K t (1 + r )  ∂K t  (1 + r ) t
(1 + r )

1 1  1  1
Recall that, by the rule of exponent = t  −1  or
(1 + r ) .
(1 + r ) t −1
(1 + r ) (1 + r )  (1 + r )t
When we substitute this in equation (6c1) gives you
∂ 1  ∂yt  1 1
= P
t  t + Pt I (1 − δ ) − Pt I−1 (1 + r ) = 0
∂K t (1 + r )  ∂K t  (1 + r ) t
(1 + r )t
∂y t
Pt = −Pt I (1 − δ ) + Pt −I 1 (1 + r ) ------------------------------------------- (3.7)
∂K t
Equation (3.7) says that the value of marginal productivity of capital or VMPK is equal
to the users cost of capital.

Finally, dividing both sides of equation (3.7) by Pt we have the expression like equation
(3.8), which shows the users cost of capital relative to the price of the product or the
marginal cost of capital is equal to the real cost of capital.

36
 ∂y t δPt I + rPt −I 1 − ( Pt I − Pt −I 1 )
= ---------------------------------- (3.8)
∂K t Pt
Where, δPt = the rate at which the investment good/capital stock depreciates at time t
I

1 =The interest charge for investment or holding capital valued at Pt −

I I
rPt − 1 the

beginning of period t
( Pt − Pt −I 1 ) = The gain or loss (overvaluation or undervaluation) in the price of
I

investment good in period t

1.2.4 Tobin’s Q theory of investment

Tobin (1969) devised a way of relating investment demand to financial variables which is
more amenable to empirical treatment than other investment models, while still having a
firm theoretical basis. In fact the crucial variable, Tobin marginal Q has already been
defined under the neoclassical model above in equation (3.7), which states VMPK is
equal to the users cost of capital. That is

∂yt
Pt + Pt I (1 − δ ) − Pt I−1 (1 + r ) = 0 ----------------------------------------- (4.1)
∂K t

Rearranging this equation gives

Pt MPK t + Pt I (1 − δ ) = Pt I−1 (1 + r ) ------------------------------------------- (4.2)

Dividing both sides of equation (4.2) by (1 +r ) , it becomes

Pt I−1 =
1
(1 + r )
[
Pt MPK t ]
+ Pt I (1 −δ) ----------------------------------------- (4.3a)

Expression (4.3a) is last year supply price of capital goods. In current time this dynamic
equation becomes
Pt =
1
(1 + r )
[
P+1t MPK t +1 ]
+ Pt I+1 (1 −δ) ------------------------------------- (4.3b)

This relationship says that the supply price of capital goods, Pt , is the discounted future
revenue stream plus the part of capital still in use. This is therefore identical to the NPV
concept discussed earlier.

Dividing the above expression first by Pt , the price of new capital goods, gives the
expression for Tobin’s marginal Q as
[1 /(1 + r )][ Pt +1MPK t +1 + (1 − δ ) Pt I+1 ]
1= -------------------------------- (4.4)
Pt

Note that the numerator has three components: the term in the first bracket is the discount
rate; inside the second bracket the first term is the additional revenue from the sale of
output and the second term is simply the increase in the value of the firm’s capital in
period t +1, that is the value of capital in next period less any depreciation. Therefore,

37
 the numerator is the increment to the value of the firm from the purchase of one more
machine, discounted back to the current period. So Tobin’s marginal Q is the rate of
change in the value of the firm to the added cost of acquiring new capital. If the firm
is in equilibrium, then Q =1 as in (expression 4.4)

Under the constant return to scale (CRS ) , from elementary theory of the firm, the
marginal cost is proportional to average cost and thus under the CRS marginal Q is
proportional to average Q. That is, marginal Q can be expressed as the ratio of the firm’s
total valuation, PV , to total cost of its capital, PK , which is known as average Q.
PV
Q= ----------------------------------------------------------------------- (4.5)
PK

1.2.5 Determinants of investment in the case of Developing Countries

Applicability:
• Tobin’s suggestion is easy to measure from the stock market, but this is not applicable
in LDC’s for the financial sector is not well developed in many developing countries
• The assumption of perfect competition is not valid because markets in LDCs are more
of imperfect than perfect
• Exchange rate is more of rationed than auctioned in LDCs
• Political instability which is more common in LDCs implies uncertainty that affects
investment adversely is not mentioned
• The existence of huge public sector investment has also an impact on private
investment; depending the type of investment. It might be complementary (such as
investment on infrastructure, transportation, electricity etc) that crowed in (encourage)
private investment or supplementary that crowed out (affect adversely) to private
investment
• Transaction cost, the cost of doing business such as bureaucracy, corruption, bribe etc
are very high in Africa.

1.3 THE SUPPLY OF AND DEMAND FOR MONEY

1.3.1 Money Supply and monetary expansion
A. MONEY STOCK (SUPPLY)
Introduction: There are three measures of money stock- M1, M2, and M3. M1 is the
narrowest of the fed’s money supply definition. It includes currency held by non-bank
private sector (or held outside bank for circulation including travelers checks (TC)) and
checkable or demand deposits held by non-bank private (firms and households) sector (
D1F + D1h = D1 ). M1 is the potential base for deposit expansion and money supply
creation.

M2 is the broadest measure of money supply than M1. It includes M1, other quasi money or
deposit (D2) such as time deposits (TD), saving deposits (SD), and money market mutual
funds (MMMFs) of individuals and firms (for example, dollar denominated deposits in
foreign banks and agreements in which a corporation purchases T-bills from a bank and
the bank agrees to buy them back the next day at a slightly higher price) on which limited

38
checks can be written. Funds in quasi deposit and MMMFs are typically regarded as
investment in short-term bonds. M2 is the most widely accepted measure of money supply.

Finally, M3 includes M2 and other assets less liquid than M2 such as money market mutual
funds held by institutions (MMMIs)-such as provident funds, pension contributions, and
saving and credit associations fund- and other assets (for example, gold deposits of
individuals) (OAs). Funds, which are not counted as part of M2, are typically invested in
long-term securities. M3 is used less frequently as a measure of money supply than M1 and
M2. In short,
M1 = C+D1 ---------------------------------------------------------------------------------------- (1)
M2 = M1+ D2 (TD+SD +MMMFs) ------------------------------------------------------------ (2)
M3 = M2+MMMIs + OAs------------------------------------------------------------------------ (3)

Monetary expansion mechanism

As we have defined it, money supply consists of currency and demand deposits which are
supplied by the commercial banks. These banks have balance sheet made up of liabilities
including demand deposits and assets reserve and loans. The Federal Reserve System
requires that commercial banks retain a certain percent of their liabilities as reserve, mainly
as deposits in the Federal Reserve Banks, in our case in the NBE. This reserve is called the
reserve requirement.

Suppose the Fed decides to expand money supply. The managers of the Fed’s open market
account buys in the bond market a certain amount of treasury bonds; say worth of Birr 100
thousand and issues a check, drawn by the Fed for Birr 100 thousand to the seller. The
seller then deposits the check in his/her checking account in Bank A, creating a Birr 100
thousand liability for the bank, the claim o the bank by the depositor and also a Birr 100
thousand in asset for the bank , the claim on the Fed. If there is a 20% reserve requirement,
bank A can loan Birr 80 thousand of its increase in assets and must retain Birr 20 thousand
as a reserve as shown in table below.

Bank A Bank B
Assets Liabilities Assets Liabilities

Br 100 Deposits 100 Br 80 Deposits 80

Reserve 20 Reserve 16
Loan 80 Loan 64

Bank C

Assets Liabilities
Br 64 Deposits 84
Reserves=12.8

39
 Loan 51.2

From the balance sheet of the three banks we understand that, the increase in money
supply from the Birr 100 thousand reserve increases is given by
∆M = 100 + 80 + 64 + 51 .2 +...,

Thus, in this simple example assuming

1. The banks are fully loaned up or there is no
excess reserve and
2. There is no linkage into increased public
holding of currency, the change in money supply is given by
1
∆M = ∆R -------------------------------------------------------- (1.3.1)
r

Where, ∆R is the initial reserve increase due to OMO and r is the reserve requirement
ratio. With the above two assumptions and reserve ratio is 20%, the initial reserve increase
will increase money supply by Birr 5 thousand
1
∆M = 100 = 5
20

Consolidated money stock

Given information regarding the reserve requirement ratio as well as assets and liabilities of
both the commercial and central/national banks the consolidated money stock/supply in an
economy can be computed and posted in the balance sheet shown in table 1.1.

Table 1.1: The Banking System Consolidated Balance sheet

National Bank
Assets Symbol Liabilities Symbol
Gold & foreign exchange reserves R High powered money H
Lending to the government LG
Commercial Banks
Assets Liabilities Symbol
Currency and deposits with the national bank Hb Deposits from the public D
Lending to the personal and corporate sector LP
Consolidated Banking sector
Assets Symbol Liabilities Symbol
Gold & foreign exchange reserves R Currency in circulation: H − H b HP
Domestic credit: LG + LP DC Deposits from the public D
Money supply: R + DC M S
Money supply: H P + D MS

3.2. Money Demand: The Transaction and Portfolio theories of money demand
1) The transaction demand for money:
Baumol and Tobin noted that money is held to smooth out the difference between
frequent income receipts and continual expenditure payments. This view of transaction

40
demand for money assumes that individuals hold all the proportion of their income that
they intend to spend in any on period in cash. Cash balances are, however, typically non-
interest bearing and so is costly to hold large amount of cash. Individuals therefore
generally choose to hold only the cash they need for current transactions while leaving the
rest in a bank deposit where it earns interest. This implies that, individuals and business
firms maintain certain average level of cash and deposits because they need to make day-
to-day transactions. If receipts of income and expenditure were always synchronized
perfectly with respect to time, there would be no need for such idle cash balances.
Because people are paid once a month or once a week and because they do not make all
their disbursements as exactly the time they receive their income, they must maintain
(hold) some amount of cash for the purpose of meeting their transaction needs.

In developing their model, Baumol and Tobin considered a hypothetical individual who
receives monthly nominal income Y (say Birr 2,400) at the beginning of the month and
spends it on transaction during the month (this period) at a uniform rate. If the individual
keeps certain proportion of money his/her income in cash to carryout transactions, then
his/her money balance follows the Saw-tooth pattern displayed in Figure 1.11. Time is
measured horizontally and the amount of money balance held at hand and balance in bank
account (bond holding) at the beginning of the time period is measured in the vertical axis.

In panel (a) we assume that the person received Y Birr of income (say Birr 2,400) at the
beginning of the month (time zero) and spends the entire amount on transaction that occur
at a uniform or constant rate during the course of the month. At the beginning of the
month he has Birr 2,400, and by the end of the month he/she has zero balance because
he/she has spent all. In other words, at the beginning of the month the person holds Y Birr
and at the end, no money (cash) left. Since money is spent at a uniform rate (constant
rate or stable intervals) throughout the month, his/her average holding of cash balance
over the course of the month is simply Y / 2 Birr (or Birr 1,200)-holding at the beginning
of the month, Birr 2,400 plus holding at the end of the month, Birr 0, divided by 2. It is
this average idle balance that we call the transaction demand for money. Household
average cash balance for n number of withdrawals over any period can be written as:
1 Y 
Mb =   --------------------------------------------------------------- (1)
2 n 

Beginning bond balance is thus

BB b = Y − BC b ------------------------------------------------------------ (2)

Where, BB b and BC b denote beginning bond and beginning cash balance respectively.

Part of money balance ( Y ) that yields return to the bond holder is called average bond
balance, which is half of beginning bond balance. It is expressed as
BBb
AV .Bb = ------------------------------------------------------------- (3)
2

Assuming for a moment there is no transaction cost (this assumption will be relaxed
shortly), net interest total revenue (TR) earned by the individual or is given by

41
  Y 1  Y 
TR = r  −   ------------------------------------------------------ (4a)
 2 2  n 

Equation (1.4a) says that net interest earned by the individual or total revenue is the rate of
interest multiplied by the unspent income in bank deposit or bond balance less the amount
withdrawn in cash in the half way point. The expression in the bracket is equal to average
bond holding. Hence, total revenue can also be written as
TR = r ( AV .Bb ) ---------------------------------------------------------- (4b)

Suppose now the household withdraws half of the money from the bank at the start of the
period and withdraws the other half at the start of the third week. When n = 2 , panel (b)
of Figure 1.11 shows that average cash balance is 1 / 2(Y / 2) = Y / 4 = 600 . Alternatively,
panel (b) can be interpreted as the case in which the individual decides to make one bond-
cash transaction by holding half of his/her Birr 2,400 in cash and put the remaining half
into income earning bonds. In other word he/she holds Birr 1,200 in cash and uses the
other Birr 1,200 to buy a Treasury bond at the beginning of the month.

Since bonds cannot be used directly to carryout transactions, he/she must sell the bonds
and turn them into cash so that he/she can carryout his/her half month transactions. Thus,
the individual’s bond holdings drop to zero at the middle of the month, and his/her cash
balance rise up to Birr 1,200. By the end of the month all the cash is gone. When he again
receives his/her next Birr 2,400 monthly payments, he/she again divides it into Birr 1,200
cash and Birr 1,200 of bonds, and the process continues. Using equation (3), the net result
of this process is that the bond balance that yields return to the individual is
1 / 2( BB b ) = 1 / 2(1200 ) = 600 . It is clear that using equation (4a) or (4b) net interest or
total revenue (TR) obtained from this process is 24. The value of marginal revenue (
∆TR / ∆n ) is also 24.

Panel (c) shows when the household makes three times (per ten days) withdrawal or two
bond-to-cash transactions. In this case, two third of the income Y (or Birr 1,600) will be
put into bonds initially. Ten days into the month, half of the bonds [ 1 / 2( 2 / 3)Y ] or third
of Y ; that is Birr 800 can be cashed. Each bond will then yield [
r[1 / 3(1 / 3)Y ] = r[1 / 9(Y )] . Ten days latter the other half can be cashed having earned
r[ 2 / 9(Y )] revenue for this third of Y . Total revenue in the three withdrawals or two
bond-to-cash transactions cases will then be r (Y / 9) + r (2Y / 9) = r (Y / 3) = 32 . You can
verify this also using equation (1.3.4a) or (1.3.4b). Marginal revenue is simply 32 less 24
or r[1 / 3(Y ) −1 / 4(Y )] = r[Y / 12 ] = 8

This analysis entails that for withdrawals greater than one ( n >1) total revenue (TR) can
also be obtained by analyzing the revenue is obtained each time when withdrawals are
made9 or bonds are cashed using the expression below.

9
Where, r / n multiplied by Y / n , 2Y / n,..., and ( n −1)Y / N indicate amount of money that yield interest
during the second , third,…, and last withdrawals. For instance, if n = 6 ( n −1)Y / N is the amount of money
withdrawn for the 5th time

42
  1  Y 2Y 3Y ( n − 1)Y 
TR = r   + + + ... + 
n  n n n n 
1 
= r  2 ( Y + 2Y + 3Y + ... + (n − 1)Y )  ---------------------------------- (5a)
n 

(a) Plan/strategy/ 1: n = 1 or no bonds-to-cash transaction

Y /2

Av. Mb =Birr 1,200

1 2 3 4 Weeks

(b) Plan/strategy/ 1: n = 2 or one transaction

Bond

Y/2=1200

Mb=Cash Av. Mb=Y/4=Birr 600

1 2 3 4 Weeks

(c) Plan 3: n = 3 or 2 transactions

Y

Bond

Y/3=800
Mb=Cash Av. Mb=Y/6=400

43
 1 2 3 4 Weeks

(d) Plan 4: n = 4 or 3 transactions

Bond

Av. Mb=Y/8=400
Mb=Cash

1 2 3 4 Weeks

Fig 1.11: Individual’s transaction demand for money

For instance, for n = 3 ,

1 
TR = r  2 ( Y + 2Y ) 
3 
1  Y   2400  96
= r  ( 3Y )  = r   = 0.04 = = 32
9  3  3  3

This revenue is the sum of r (Y / 9) & r (2Y / 9) which give net earning equal to 10.67 and
21.33 in the second and third withdrawal or first and second bond-to-cash transaction.

Finally, panel (d) depicts that if the household makes four times (weekly) cash withdrawal
or three times bond-to-cash transactions. In this case the average cash balance held is only
Birr 300 or Y / 8 , which is [1 / 2(1 / 4)Y ] .These example shows that the average cash
balance held by the individual household falls as the number of cash withdrawals
increase.

Examples above prompt the question as to what determines the number of withdrawals or
transactions ( n ) demand for money at any given period. There are two main factors.
First, since a bank deposit account offers interest on funds remaining in the account, as
interest rate rise households will economies/decrease their holding of idle/average cash
balance for transaction purpose, thereby increasing n . In figure 1.12 below, other things
being equal, the number of withdrawals that maximize the TR of the individual increases
from n0 to n1 when the market interest rate increases from r0 to r1 Therefore, the

44
 transaction demand for money is sensitive and inversely related to the level of interest
rate.
Assuming the interest rate is 4% per month and no transaction cost, the expression for the
net interest or total revenue earned when the individual makes two to five times
withdrawal or one to four bonds-to-cash transactions at a constant interval using equation
(1.5) will be:
 For n = 2
 1  1  Y 96
r   Y  = r = = 24
 2  2  4 4
 For n = 3
 1  1  2  1  Y Y 96
r   Y  +  Y  = r = 0.04 = = 32
 3  3  3  3  3 3 3
 For n = 4
 1  1  2  1  3  1  6Y 3Y 288
r   Y  +  Y  +  Y  = r = 0.04 = = 36
 4  4  4  4  4  4  16 8 8
 For n = 5
 1  1  2  1  3  1  4  1  10Y 2Y 192
r   Y  +  Y  +  Y  +  Y  = r = 0.04 = = 38.4
 5  5  5  5  5  5  5  5  25 5 5

Results discussed so far regarding the revenue side of transaction demand for money are
is illustrated in table 1.2 below given r = 4% and no transaction cost.

Table 1.2: Marginal revenue from increasing transactions from bonds to cash
Initial (Beginning) Average (mid point)
No of withdrawal ( Cash Bond Cash balance Bond Total Marginal
n) & duration balance Balance( Bb (M b ) balance Revenue Revenue
)
Amount (Y − M b ) ( BM b / 2) ( BB b / 2) r ( AV .Bb ) ∆TR / ∆n
withdrawn
1(beginning of Y=2,400 - 1,200 - - -
the month)
2 (Per 15 days) Y/2=1,200 Y/2 =1,200 ¼(Y)=600 ¼(Y)=600 24 r(Y/4)=24
3 (Per 10 days) Y/3= 800 2/3(Y) =1,600 1/6(Y)=400 1/3(Y)=800 32 r(Y/12)=8
4 (Per 7 days) Y/4= 600 ¾(Y) =1,800 1/8(Y)=300 3/8(Y)=900 36 r(Y/24)=4
5 (Per 5days) Y/5= 480 4/5(Y) =1,920 1/10(Y)=240 2/5(Y)=960 38.4 r(Y/40)=2.4
Note: TR in this table is computed on the assumption that transaction cost is zero. In this case TR and net
interest earned are equal. However, TR will be greater than net interest earned when transaction cost is
involved in making transaction.

From these strategies, it is clear that:

1) The lower the average holdings of cash balance and
the higher the bond holding the more interest the individual will earn. But increases
at a decreasing rate
2) The marginal revenue from increasing the number
of transactions is positive and decreasing as the number of transactions n increases.

45
 3) Looking at the differences in MR column in table
1.2, we can see that as n increases the drop in MR decreases. This gives us
MR ( r0 ) curve in figure 1.12, which shows MR is a function of the number of
transactions n for given interest rate ro
The second factor that determines the size of n is the transaction cost in terms say cn .
On the cost side, we assume that each transaction has a give cost, c , perhaps a brokerage
fee for the buying and selling of bonds, the implicit cost of time spent transacting
business, transportation cost, or trouble of making frequent visits to the bank in order to
affect cash withdrawals, for making more trips. Then we can add a MC schedule to the
figure 1.12. Combining with the initial MR (r0 ) curve gives the profit maximizing
number of transaction n0 , where MR = MC . similarly, the number of withdrawals will be
n1 when interest rate increases from r0 to r1

MR , MC

MC 1
MC 0

MR ( r1 )
MR ( r0 )

n0 n2 n1 n
Figure 1.12: Determination of the number of transactions

The above figure also indicates that as transaction cost per withdrawal or MC increases
from MC 0 to MC 1 other things being equal, the number of withdrawals made by the
individual decreases from n1 to n2 .This also mean that average cash holding will
increase and that of bond balance or deposits will likely be decline.

When making withdrawal or converting bond-to-cash involves transaction cost the TR is

not also net interest earned on average bond holding, which is shown in column 6 of table
1.2 for the net declines by the amount of transaction cost multiplied by the number of
withdrawal. Instead, TR is considered as gross interest earning. The expression net interest
( NI ) when transaction cost is involved thus
NI = r ( AV .Bb ) − cn ------------------------------------------------------ (5b)

For example assume that transaction cost per withdrawal is Birr 2. In this case, when an
individual makes 2 withdrawals transaction cost will be Cn = 2 x 2 = 4 . Thus, net interest
will be 24 minus 4, which is equal to Birr 20. Similarly, net interest ( NI ) declined by Birr
6, 8, and 10 when 3,4, and 5 withdrawals were made.

Aggregate money demand

46
To move to the aggregate money demand for each representative consumer whose money
transaction balance is given by equation (1), there is assumed to be someone on the other
side of the market. Suppose, for example that the consumer buys goods from a
representative firm and that firm periodically converts its money holding into bonds. The
firm’s pattern of bond and money would follow the same saw-tooth pattern exactly
complementary to the consumers’ pattern in Figure 1.11. The aggregate money DD in the
transaction s model is therefore, the sum of the households’ demands and that of the firms
on the other side of the market. This means that we must double, M b in equation (1) to
get the aggregate demand for real money balance M Td / p . Aggregate money transaction
balance or simply cash balance in nominal and real term are given by
Y
M Td = 2 M b = ----------------------------------------------------------- (6a)
n
M Td Y
= 2mb = ----------------------------------------------------------- (6b)
P n

Where, the subscript T indicates aggregate or total.

Exercise 1.4:
1) If interest rates on bonds go to zero, what does the Baumol-Tobin analysis suggest the
individual’s average holding of money balances should be? Explain
2) If brokerage fees or time and transportation cost go to zero, what does the Baumol-
Tobin analysis suggest regarding total revenue and net interest earning on holding of
money balances should be? Explain
3) Consider an individual who earns Birr 3600 per month, who can earn 5% interests per
month on saving deposits, faces Birr 2 transactions cost per withdrawal, and has an
initial withdrawal plan of 4. Moreover, assume that the individual’s elasticity of
withdrawal with respect to change in interest rate and transaction cost are ½ and 2
respectively. Given the above information:
(A) Compute the individual’s average monthly cash and bond
balances for the information given above and illustrate the values using the saw-
tooth pattern graph.
(B) Other things remain constant, by how much will the individual’s
number of withdrawals and hence average monthly cash and bond balances change if
the rate of interest falls to 3%?.
(C) While interest rate remains constant, what will happen to the
number of withdrawals and hence individual’s average monthly cash and bond
balances change if transaction cost declines to Birr 1? Calculate the values and show
graphically
(D) Compute the net interest earned from money kept in the bank or
holding of short term bonds in the case of (a) to (c) by rounding the values to nearest
whole number.

1.3.2. The Portfolio Approach (Reading assignment)

47
 Introduction: According to Keynes, the demand for real money balance function, divided
into speculative component, inversely related to interest rate, and transaction component,
positively related to income and inversely related to interest rate, is given by
M
= m = f ( r , y ) ≈ l (r ) + k ( y ) ------------------------------------ (1)
P
Where, ∂m / ∂r is negative and ∂m / ∂y is positive

The portfolio approach is attributed to Keynes speculative (regressive) expectations model

and described by Tobin in his article on liquidity preference. The portfolio approach says
that people hold money when they expect bond prices to fall, that is, interest rates to rise,
and thus expect that they would take a loss if they were to hold bonds. Since people’s
estimates of whether the interest rate is likely to rise or fall, and by how much, vary fairly
widely, at any given interest rate there will be someone expecting it to rise, and thus
someone holding money.

The obvious problem with the liquidity preference theory of Keynes is that it suggests
individuals should, at any given time, hold all their liquid assets either in money or in
bonds, but not some of each. This is obviously not true in reality. Tobin’s model of
liquidity preference deals with this problem by showing that since the return on bonds is
uncertain, that is, bonds are risky, then the investor worrying about both risk and return is
likely to do best by holding both bond and money-diversification of portfolio.

Tobin assumes that a bond holder has an expected return on bond from two sources, the
bond’s yield – the interest payment an individual receives – and a potential capital gain
– an increase in the price of the bond from the time he/she buys it to the time he/she sells
it. The bond’s yield Y is usually stated as a percentage of the face value of the bond. The
market rate of return on the bond r is the ratio of the yield to the price of the bond Pb .

For example, if a hundred-dollar bond has a yield of $5, the percentage yield is 5 percent.
If the price of the price of the bond rises to $125, the $5 yield corresponds to a market rate
r of 4 percent - $5/$125. Thus, the market rate is given
Y
r = --------------------------------------------------------------
Pb
- (2)

And, since the yield Y is a fixed amount stated as a percentage of the bond’s face value,
the market price of a bond is given by
Y
Pb = -------------------------------------------------------------
r
- (3)

The expected percentage capital gain g is the percentage increase in price from the
purchase price Pb to the expected sale price Pbe . This gives us an expression for the
percentage capital gain; g ( Pbe − Pb ) Pb . From equation (2) and (3), with a fixed Y on the

48
 bond, an expected price Pb corresponds to an expected interest rate r = YPb . Thus, in
e e e

terms of expected and current interest rates, the capital gain can be written as
Y Y
e
−
g= r r
Y
r
Canceling, the Y terms and multiplying the numerator and denominator by r gives us
r
g = e − 1 ----------------------------------------------------------
r
(4)

As the expectation for the expected capital gain in terms of current and expected interest
rates. For example, if the present market interest rate is 5 percent and the purchaser of the
bond expects the rate to drop to 4 percent, his expected capital gain would be
0.05
g= −1 = 1.25 −1 = 0.25 or 25%
0.04

The total rate of return on a bond - e for earnings – will be the sum of the market rate of
interest at the time of purchase and the capital gains term. Thus,
e = r + g --------------------------------------------------------- (5)

And substituting for g from equation (5), we have an expression for the total rate
(percentage) of return
r
e = r + e − 1 -----------------------------------------------------
r
(6)

James Tobin in his famous article “Liquidity Preference as Behavior towards Risk”
formulated the risk aversion theory of liquidity preference based on portfolio selection.
This theory removes the following two major defects of the Keynesian liquidity
preference theory.
1) Keynes’s liquidity preference function depends on the inelasticity of
expectations of future interest rate, and
2) Individuals hold either money or bond.

Tobin starts his portfolio selection model of liquidity preference with this presumption
that an individual asset holder has a portfolio of money and bonds, even if the return
from bonds is higher that the return from money. Money neither brings any return nor
imposes any risk on holders. But bonds yields interest and also bring income. However,
income from bonds is uncertain because it involves a risk in capital gains and losses. The
greater the investment in bonds the greater is the risk of capital loss from the bonds. An
investor can bear this risk if he/she is compensated by an adequate return from bonds.

As a result, the portfolio balance approach begins with the same expression to the total
percentage return- e - that we have developed in equation (5) earlier.

49
 e=r+g

We have also assumed earlier (under 4) that the percentage rate of expected capital gain
given by
r
g = e −1
r

is determined with certainty by the individual: he chooses r e as a function of r and no

consideration of uncertainty or risk enters the problem. The basic contribution of the
portfolio balance approach is to enter risk contributions explicitly into the
determination of the demand for money.
If g is the expected capital gain or loss, it is assumed that the investor bases his/her
actions on his /her estimate of its probability distribution. It is further assumed that this
probability distribution has an expected value of zero and is independent of the level of
the current rate of interest, r , on bonds. Now in place of a return expected with
−
certainty, e , we can have an expected return, e , where
− −
e = r + g -------------------------------------------------- (7)
−
And g is the mean expected capital gain from the probability distribution.

The Individual portfolio Decision

Individual portfolio consists of a proportion M of money and B of bonds where both
M and B add up to one. They do not have any negative values. If asset holder is putting
B dollars of his/her liquid assets into bonds, his/her expected total return on a
−
portfolio RT is then
− − −
RT = B. e = B(r + g ) , where 0 ≤ B ≤ 1 ----------------- (8)

Similarly, if the standard deviation of the probability distribution of return/capital gains

on a bond is σg , which is a natural measure of uncertainty or riskiness of bonds, a
number like 2 percent, and all bonds are alike, then the total standard deviation of bond
holding is given by
σT = B.σg -------------------------------------------------- (9)

Equation (11) and (12) give us the technical situation facing the asset holder – the budget
constraint along which he/she can trade increased risk σT for increased expected return
−
RT . They also give the investor a formula for deciding how much funds to put into
bonds to achieve a given risk-return mix along the budget line. From (9) we have

σT 1
B= = σT
σ g σ g ------------------------------------------ (10)

50
With σg fixed by the asset holder’s probability distribution (10) gives the total bond
holdings B needed to attain any given level of risk σT . Using this expression to replace
B in (8) gives us the budget constraint,
 −

− σT −
r + g 
RT = (r + g ) = σ T  -------------------------- (11)
σg  σ g 
 
Here r is a known current vale, fixed, at least to the individual, by the bond market. The
−
investor knows g and σg , at least implicitly, from the probability distribution g ' s in
Figure 1.13. Thus, the expression in parenthesis (13) is a given, determined number which
−
gives the constant rate of trade-off between return RT and risk σT . Differentiating (11)
we have
− −
d RT r + g
= ------------------------------------------ (12)
dσ T σg

−
If r is 5%; −
g is 15% and σg is 5%, then d RT / dσ T is 3%. In this case, an increase of
one percentage point in the standard deviation in the total portfolio σT will buy a 3%
−
increase in the expected total return RT .

Tobin describes three types of investors. The first category is of risk lovers who enjoy
putting all their wealth into bonds to maximize risk. They accept risk of loss in exchange
for the income they expect from bonds. They are like gamblers. The second category is of
plungers. They will either put all their wealth into bonds or will keep it in cash. Thus,
plungers either go all the way or not at all.

But the majority of investors belong to the third category. They are risk averse or
diversifiers. Risk averters prefer to avoid the risk of loss which is associated with holding
bonds rather than money. They are prepared to bear some additional risk only if they
expect to receive with it greater increases in returns. They will, therefore, diversify their
portfolios, and hold both bonds and money. Although, money neither brings any return
nor any risk, yet it is the most liquid form of assets which can be used for buying bond
any time.

In order to find the risk averter’s preference between risk and expected return, Tobin uses
indifference curves having positive slopes indicating that the risk averter demands more
expected return in order to take more risk.

σR I2
I1 r
T

51
 O Risk ( σR )
B
P E
M
W C

Fig 1.13: The “diversifier’s” portfolio selection between risk and

return
In Figure 1.13, the horizontal axis measures risk ( σR ) and the vertical axis the expected
return ( RE = µR ). The line Or is the budget line of the risk averter. It shows both the
risk and return on the basis of which he/she arranges his/her portfolio of wealth
consisting of money and bonds. I1 and I 2 are indifference curves. An indifference curve
shows that he/she is indifferent between the pairs of expected return and risk that lie on
I1 curve. Points on curve are preferred to those on I1 curve. But the risk averter will
achieve an equilibrium position between expected return and risk where his/her budget
line is tangent to the indifference curve ( I1 ), at point T .

In the lower portion of the figure the length of the vertical axis shows wealth held by the
risk averter in his/her in his portfolio consisting of money ( PW ) and bonds ( OP ). The
line OC shows risk as a proportional to the share of the total portfolio held in bonds.
Thus, point E on this line drawn as a perpendicular from the point T determines the
portfolio mix of money and bonds. It is OP of bonds and PW of money. Thus, the risk
averter diversifies his/her total wealth OW by putting partly in bonds ( OP ) and partly
keeping in cash ( PW ). That is why he/she is called a diversifier. He/she is not prepared
to accept more risk unless he/she can also expect greater expected return. However, the
risk averter possesses an intrinsic preference for liquidity which can be only offset by
higher interest rates.

The aggregate demand for money in the portfolio balance model

The higher the interest rates, the lower the demand for money and the higher the
incentive to hold more bonds. On the contrary, the lower the interest rates, the higher the
demand for money and the lower the willingness to hold more bonds. This is illustrated in
Figure 1.14 below.
I3
r3
Expected r2
Return T3 I2

T2 I1 r1

T1
O

52
 Risk
B1 E1
Wealth B2 E2
B3 E3

W C

Fig 1.14: Aggregate Portfolio selection with rising interest rates

In Figure 1.14 the slope of the budget line increases with the increase in the interest rate.
This is shown by the budget line r1 rotating upward to r2 and r3 . Consequently, returns
increase in relation to risk with increase in interest rate and the budget line touches higher
indifference curves. In Figure 1.18, budget lines r1 , r2 ,and r3 are tangent to I1 , I 2 ,and I 3
at T1 , T2 , and T3 respectively. These points trace out the optimum portfolio curve, OPC
in the figure, which shows that as the tangency points move upward from left to right, both
the expected return and risk increase.

These tangency points also determine the portfolio selection of risk averters as shown in the
lower portion of Figure 1.15. When rate of interest is r1 , people hold OB 1 amount of bond
and B1W money. As the rate of interest increases from r1 to r2 and r3 , risk averters hold
successively more bonds OB 2 and OB 3 but reduce money to B2W and B3W in their
portfolios.

The figure also shows that as the rate of interest increases by equal amount from r1 to r2 and
to r3 , risk averters hold bonds by decreasing increment B2 B3 < B2 B1 < OB 1 . This also
means that the demand for money falls by smaller amounts, as the rate of interest increases.
This is because the total wealth in the portfolio consists of bonds plus money. The demand
for money can be drawn on the basis of Figure 1.14 and derived in Figure 1.15 below. The
curve shows that when the rate of interest falls from a higher level, there is a smaller increase
in the demand for money.

Interest
Rate

r10
r8
r6
r4
r2 Md

O A B C D Speculative DD for
money

Fig 1.15: The demand for money

53
For instance, when the rate of interest falls from r10 to r8 the demand for money increases
by AB amount, which is smaller than OA . This is because the risk averters prefer to hold
more bonds than money. But when the rate of interest falls at a lower level from r4 to r2
the increase in the demand for money is much larger; CD in figure 1.15. This demand for
money relates to the speculative demand for money not to the aggregate demand for
money.

1.4 Labour market

1.4.1 Labour demand
(A) Individual firm labour demand
Introduction: The demand for labour is a derived DD. That is to say firms do not demand
labour for its own sake but for what it is able to produce for sale in conjunction with other
factors of production, such as capita. It follows, therefore, that firms will only demand
labour if it is profitable to do so. It will be profitable to employ more labour in the marginal
revenue earned from the sale of extra output exceeds the marginal cost of producing that
output. Hence, the demand for labour by an individual firm operating in competitive
markets is based on the notion of profit maximization. Profit maximization implies that
additional labour will be demanded until the marginal cost of labour (real wage) just equals
the marginal revenue of labour obtained from the sale of extra output produced by the
marginal worker. The marginal revenue and marginal cost of a firm is determined by the
state of technology and the nature of production function. Figure 1.16 shows the production
function, which describes real output ( Y ) is a function of labour input and the capital
−
stock. The capital stock is fixed at K , which implies that this model of labour market is
strictly a model of the short run.

Y
−
Y = f (N, K )

N1 N 2 N3 N
APN , MPN

AP N = y / N

N1 N2 MP N

54
 Fig 1.16: The production function
−
The shape of the production function, y = y ( N , K ) , shows Y increases with labour input,
so that ∂y / ∂N > 0 . Initially output increases at an increasing rate with the first additions
of labour to the capital stock, shown over the range ON 1 in Figure 1.16. Beyond the level
of employment given by N1 , however, Y begins to increase at a decreasing rate,
exhibiting diminishing marginal returns as the fixed capital stock is shared among more
and more workers.

In the lower panel of Figure 1.16, the relationship between the production, average and
marginal product of labour. It can be seen that as employment increases the AP N first
increases up to N 2 and then decreases beyond N 2 .The MP N , which represents the
additional output produced by the last worker employed and is derived from the slope of
the production function. The slope is initially rising, peaking at N1 , the point of inflection
point where the production function changes from convex to concave, and then falling
beyond N1 ; intersects the AP N at its maximum, and reaches zero at N 3 , where the
production function becomes flat. Beyond N1 the MP N therefore, falls with N, that is
∂2 y / ∂N 2 < 0 , and the MP N exhibits a diminishing marginal product of labour.

With this information the firm’s labour demand decision can be examined. First, the
employment of one more worker will lead output to rise by the MP N . If the addition
to total output is sold in a competitive market, such that the price it sells for is the same as
that for all previous units, then marginal revenue received by the firm is the price of
−
output multiplied by the MP N ; P.MP N . This is called the marginal revenue product of
labour ( MRP N = VMP N ). Thus the profit maximization condition where by the marginal
cost of extra worker is the money wage, W, equals marginal revenue product of labour is
given as
− −
π = P . y ( N , K ) −WN ------------------------------------------- (1)
∂π
Ld = = 0 ------------------------------------------------------ (2)
∂L
∂y
=P −W = 0
∂L
∂y
= MRP N = P = W --------------------------------------- (3)
∂L

This indicates that at equilibrium MRP N is equal to nominal wage. Alternatively, labour
demand is also written in real term as
∂y W
Ld = = = w ------------------------------------------------ (4)
∂L P

The above expression entails that firms determine how much labour to hire by equating
MPL = MC L = w . The marginal cost of the firm is real wage. In Figure 1.16, the MP N

55
falls as N increases, beyond N1 , the demand for labour is inversely related to real wage
rate. Since the price deflator used in the calculation of real wage rate is the price of the
firm’s output, this measure of real wage is referred as the real product wage.

(B) Aggregate labour demand

In the aggregate it is assumed that the demand for labour is the horizontal summation of
individual firm’s demand for labour, which gives the downward slopping curve as depicted
in Figure 1.17 below. The aggregate demand for labour function is therefore denoted as
W
Ld = w = = f (N ) Or W = P. f ( N ) ----------------------------- (5)
P

Where f ( N ) denotes the economy wide MP N schedule. Since the marginal product of
labour schedule falls as N increases f ( N ) < 0 and the real product wage is inversely
related to the aggregate demand for labour.

W
P

W0
P

f (N )

N0 N
w

w0

P. f ( N )

N0 N
Fig 1.17: The aggregate Demand for labour

1.4.2 LABOUR SUPPLY

Introduction: The individual supplier of labour is assumed to supply labour in direct relation to
the real (consumption) wage. In developing the aggregate demand for labour, we do not make any
explicit assumption about price or wage expectation of employers on the demand side of the
labour market. This is because we assume that an employer has good information on or perhaps
control of the particular prices changed and the wage rate paid. The employer is thus in a position

56
to know the real wage at each point in rime. For the employer, this real wage ( w ) is the money
wage deflated by the particular employer’s product price ( P ).

However, a worker’s information concerning price level (and subsequently about his/her real
wage) is not adequate as that of the employer. This is because workers may not know in advance
exactly what products will they need to purchase with their money (nominal) wages and second,
even if they did, they do not know the exact prices (consumers price index) of the goods in
advance. Thus, a worker must deflate his/her nominal/known wage income (W) by a an estimated
consumers price index (CPI) or P e that covers a wide range of products in order to arrive at an
estimated or expected real wage, we . Therefore, an explicit assumption linking workers
estimation or expectations on price level ( P e ) and the actual price level ( P ) is important.
Hence, it is important to note that the price deflator used by the worker when deciding the
amount of labour to supply is different from the price level used by the producer in determining
how much labour to employ. These two real wage rates are referred to as the expected wage-
W / P e (or we ) and the real producer wage- W / P (or w ) respectively.

THE AGGREGATE LABOUR SUPPLY CURVE

This is obtained by summing all individual labour supply curves for a given expected
wage rate ( P e ) to get the aggregate labour supply curve for the entire economy; that is
∑n = N . Therefore, the aggregate supply curve of labour in expected price can be
represented mathematically as:
N = N ( we )
W
In real value: L = w =
s e
= g ( N ); g ′ > 0 ----------------------------- (6a) or
Pe
In nominal value: Ls = W = P e .g ( N ) ----------------------------------- (6b)

In equation (6a), g ( N ) = W / P e can be written in the current actual real wage ( w ) and
the level of employment, N , relationship by converting the expected real wage ( we ) in
to the actual real wage ( w ). By definition:
W Pe W
LS = w = e . , by substituting e by g (N ) from equation (6a)
P P P
Pe
LS = w = g ( N ). ----------------------------------------------- (7a)
P

This is another version of equation (6a). However, the labour supply function in nominal
wage derived from equation (7) is similar to that of (6b). That is
Ls = W = P e .g ( N ) ---------------------------------------------- (7b)

Aggregate labour supply ( LS ) derived in current actual real and nominal wage rather
than expected real wage (equation 7) are depicted graphically as follows,

57
 Pe
w w= .g ( N )
P

w0

N0 N

W W = P e .g ( N )

W0

N0 N
Fig 1.18: Aggregate labour supply Curve

1.4.3. Frictionless Labour Market Equilibrium and the Aggregate Supply Curve
(A) Frictionless Labour Market Equilibrium (Classical equilibrium)
We have already derived that the aggregate demand and supply of labour equations in the
labour market, both as a function of real and nominal wage in equation (5) and (7)
respectively, as
W
Ld = = w = f (N ) Or W = P. f ( N ) ; equation (5)
P
Pe
Ls = w = .g ( N ) Or W = P e .g ( N ) ; equation (7)
P

The labour market equilibrium is obtained by equating labour DD ( Ld ) to labour SS ( Ls

).That is,
Pe
In real wage: f ( N ) = .g ( N ) ---------------------------------------- (8)
P
In nominal wage: P. f ( N ) = P .g ( N ) ---------------------------------- (9)
e

The graphic representation of labour market equilibrium is represented by the intersection

of the two curves indicated in equation (8) and (9) above. For a given value of actual price
level, P0 and the expected price level P e equilibrium real and nominal wage are w0 and
we , respectively while equilibrium employment is N 0 , and real income, y0 .

58
At point E the labour market clears. But this does not imply that there is zero
unemployment. Note that if all the workers are in employment the labour supply curve
would become vertical since no matter how high real wages were pushed up, there could
be no increase in employment because all workers are employed. In Figure 1.19 the level
of full employment is given at N F . The distance between N F − N 0 therefore denotes the
level of voluntary unemployment. The level of voluntary unemployment expressed as a
percentage of total labour force in an economy is usually referred to as the natural rate of
unemployment. The voluntary unemployment due to the labour market frictions is
frequently believed to consist of two specific kinds of unemployment, namely frictional
unemployment and structural employment.

Frictional unemployment is explained by the special characteristics that it takes time to

match workers to jobs. In reality however, workers have different preference and abilities
and jobs have different characteristics and the geographical mobility of workers is often
low. Hence, searching job takes time and effort and because different jobs require different
skills and pay different wage rates, unemployed workers may not accept the first job offer
they receive. The unemployment caused by the time it takes workers to search for a job is
called frictional unemployment.
w
Pe
Ls = w = .g ( N )
P0

w0 E

Ld = w = f (N )

N0 NF N

W
LS = W = P e .g ( N )

W0 E
Ld = w = P. f ( N )

N0 NF N
Fig 1.19: Equilibrium in the labour market

As structural change occur in the economy, some industries of the country may decline and
some labour skill categories become redundant as others expand. This can lead to
structural unemployment.

59
Thus, the natural rate of unemployment or the level of employment consistent with the
labour market clearing is voluntary in the sense that the number of job vacancies is equal
to the number of workers seeking job. In other words, the natural rate of unemployment
means frictionless labour market equilibrium. It corresponds to the classical labour
market equilibrium. Because the classical assume that workers have perfect foresight of the
current and expected price levels and hence price and wage rates are flexibility conclude
that the labour market always clears both in the short and long run along the aggregate
supply (AS) curve. Thus any changes in unemployment are entirely voluntary.

(B) The Aggregate Supply (AS) Curve

Aggregate supply curve is derived from the aggregate labour market and production
function to give a direct relationship between output and price level for a given state of
technology and the work-leisure preference of workers.

The derivation of the AS curve is based on the labour market equilibrium expressed in
real and nominal wages as Ld = Ls . That is
Pe
(1) w = f ( N ) = .g ( N )
P
Real product wage or MP L = Real consumption (money) wage
(2) W = P. f ( N ) = P e .g ( N )
Actual money wage = Expected nominal wage

The degree to which the expectation of workers about P e adjust to the movement of P is
given by
P e = α( P ); 0 ≤ α' ≤ 1 ------------------------------------------- (10)
Where, α' is the slope of the price function (or ∂P e / ∂P ) and its value lies between 0 and 1

Now let us see first what will happen to labour market equilibrium level of employment,
income, and wage (real and nominal) rates of the classical and extreme Keynesians as the
price level changes and then derive their aggregate supply (AS) curves. To do so, we
assume for simplicity the following two assumptions:
1) Initially both actual and expected prices are equal or P0e = P0 and
2) The price level rises from P0 to P1 .

With these assumptions we can then derive the classical AS curve of the frictionless
(classical) and extreme Keynesians school of thoughts by examining what happens to the
equilibrium level of employment, income and wage rates for a closed economy (an
economy without international trade)as price level increases exogenously?

a) The extreme Classical case:

The basic assumption of the classical regarding the labour market is that there is complete
and correct adjustment or perfect foresight of P e to P .That is ∆P e = ∆P and hence α = 1
in equation (10) above. This assumption stems from its two core assumptions about the
aggregate economy: price and wage flexibility and economic agents are rational.

60
When P e moves by the same proportion as P rises from P0 to P1 or α = 1 , the ratio of
P e / P remains unchanged. This is evident from Figure 1.20(a) below that when the
expected price P e fully adjusts to the change in the actual price the labour market
equilibrium remains at point A leaving the initial labour market equilibrium value, w0 and
N 0 space undisturbed. This is known as the classical result, in which movements of the
price level do not affect equilibrium level of employment and real wage.

In the second figure, however, an equal (proportional) increase of P and P e shifts the
labour demand and supply curves up by the same amount (magnitude), again leaving N 0
undisturbed. In Figure 1.20(b), the exogenous increase in actual price from P0 to P1 shifts
the labour demand up (or to the right) from the initial P0 . f ( N ) to P1. f ( N ) . This is
because, the increase in price level reduces real wage and hence encourages employers to
demand more labour and increase production. The rise in the price level can be shown by
the vertical distance AB , because the price level is combined multiplicatively with the
marginal product of labour increase.

On the supply side of labour market, the higher price level translates into a higher
consumer price index (CPI), so workers will perceive a fall in their real wages, and so
contract/reduce their labour supply to the labour market. As a result, the labour supply
curve shifts up (to the left) proportionally as far as the demand curve from P0e .g ( N ) to
P1e .g ( N ) . This proportional shifts the labour demand and supply curves in turn hold
equilibrium employment at N 0 .The implication of proportional shift of labour supply to
that of labour demand is that MC has increased by the same proportion to that of MR. With
employment fixed at N 0 output ( Y0 ) also becomes fixed at Y0 = f ( N 0 , K ) in figure
19c. Therefore, we can conclude that with α = 1 or perfect foresight of P e to P only the
nominal wage rate ( W0 ) rises by the same proportion to the increase in price level,
holding equilibrium real wage, employment, and income constant at w0 , N 0 ,and Y0
respectively.

The insensitivity of equilibrium level of employment ( N 0 ) and output/income ( Y0 )

when the price level rises from P0 to P1 due to perfect foresight ( α = 1 )of workers
about the change in price in a closed economy give us a VERTICAL AGGREGATE
SUPPLY CURVE of the classical as shown in Figure 1.20(d).

Pe
w Ls = .g ( N )
P0

w0 A
(a)

61
 Ld = f (N )
N0 N
e
W P .g ( N )
1

P0e .g ( N )

W1 B
(b)
W0 A
P1. f ( N )
P0 . f ( N )

N0 N

Y Y

Y (N )
(c) Y0

45 0
N0 N
P Y = AS = Y ( g ( N ), f ( N ), EP * )

P1 B′
(d) P0 A′

Y0 Y

Fig 1.20: The Classical Labour market equilibrium and Aggregate supply (AS) curve

b) The extreme Keynesians Case:

This is the opposite of the extreme classical case. That is, the extreme Keynesians assume
zero (no) adjustment of the expected price level ( P e ) as the actual price level changes
from P0 to P1 . Hence, when P0e = P1e or α = 0 , implying imperfect foresight (myopia or
shortsightedness) or complete money illusion. This is because of the assumption of price
and wage rigidity and static expectation of economic agents about price level.

62
With P e constant as the price level changes labour supply depends only the money
(nominal) wage rate- W . When there is no adjustment of P e to P , only the demand for
labour curve shifts to the right along the unchanged labour supply curve from P0 . f ( N )
to the higher P1. f ( N ) in figure 1.21b due to the decline in real wage. Since the increase
in the price level has shifted only the labour demand curve, but not the labour supply
curve, employment raises from N 0 to N1 and the nominal wage from W0 to W1 . Hence,
unlike the classical case where the nominal wage raises proportional to the change in the
price level nominal wage in the extreme Keynesian case rises by less than the rise in the
price level for expected price ( P e ) is fixed due to myopia.

The less than increase in nominal wage than the price level is then followed by a decrease
in real wage (see panel Figure 1.21a). In Figure 1.21a, the rise in P with unchanged P e
reduced the ratio of P e / P from P0e / P0 to P0e / P1 and hence shift the labour supply curve
e
in the w, N space to the right. Thus, the rigidity of price expectations at P0 on the supply
side of the labour market permits a reduction of the real wage rate as the price level
increases, inducing an increase in equilibrium employment from N 0 to N1 (see panel a
and b) and hence output/income from Y0 to Y1 (see panel c).

With P e given and not responsive to changes in actual P ( α = 0 ), the above equilibrium
condition in the labour market not only gives the equilibrium employment N depending on
the price level P but also the aggregate SS curve with a positive slope. This is because as
price increases, shifting the labour DD up, the labour market equilibrium N moves up
along the given labour supply curve in the W , N space. Therefore, if the money illusion
assumption or α = 0 holds the labour SS curve is constant, generating an increase in
employment and output and upward sloping AS curve.

The extreme Keynesians are criticized on the ground that the assumption of α = 0 is
appropriate to examine the impact of the movements of price level on equilibrium level of
employment and output during the market period (i.e., very short period of time where
supply cannot respond to demand) when the labour force has not had time to absorb new
price information on price level and adjust P e to P . This criticism gave rise to the new
(general) Keynesian theory of labour market, which postulate though the degree of
adjustment of workers expected price to actual price improves with the availability of
information in the long run, the shape of the aggregate supply curve is always upward
sloping and the equilibrium level of employment and output higher than the classical but
lower than the extreme Keynesians.

P0w
Ls0 = .g ( N )
w P0
P0e
L1s = .g ( N )
P1
w0 A (a)

63
 w1 B

Ld0 = f ( N )

N 0 N1 N
e
W P .g ( N )
0

W1 B
(b)
W0 A
P1. f ( N )
P0 . f ( N )
N 0 N1 N
Y Y

Y1 B Y (N )
Y0 A
(c)

45 0
−
N0 N1 N Y = AS = Y + α ( P − P e )
P

P1 B′
(d)
P0 A′

Y0 Y1 Y

Fig 1.21: Labour market Equilibrium and AS curve for extreme Keynesian
1.4.4. The New Keynesian view of the labour market
This model is some how in between the two extreme (polar) assumptions-the extreme
classical and the extreme Keynesian. The aggregate supply curve of in the general
Keynesian model, at least in the short run, in which 0 < α < 1 . That is, the model in which
expectations adjust to changes in the actual price level, but not fully. It could be labeled as
imperfect foresight model.

In Figure 1.22 below, adjustment of the labour market equilibrium to an exogenous

increase in the price level from P0 to P1 by less than the exogenous increase in P .
Figure 1.22(a) shows that the increase in P reduces the ratio of the expected to actual
e e
price level from P0 / P0 to P0 / P1 since adjustment expectation is less than perfect or

64
α < 1 . This shifts the labour supply curve down in the w, N space reducing real wage
and increasing employment from N 0 to N1 . The same movement is also shown in the
W , N space of Figure 1.22( b )where we see the increase in P shifts the demand curve
up from P0 . f ( N ) to P1. f ( N ) while the rise in P e shifts the labour supply curve up,
e
but only by less than the movement in the demand curve, from P0 . f ( N ) to P1e . f ( N )
and cutting the demand curve at point C in stead of at point B , since α < 1 .

Furthermore, the excess demand for labour at W0 pulls up the nominal wage to W1 , an
increase less than proportionate to the price level, since dP e < dP . Thus, employment rises
to N1 . The movement in employment is translated to the change in output in Figure
1.22(c), using the production function. Finally, an upward sloping aggregate supply curve
passing through ( P0 ,Y0 ) and ( P1 ,Y1 ) pairs is obtained in panel d . This implies that the
less than perfect foresight assumption eliminates the verticality and flatness of aggregate
supply curve of the classical and extreme Keynesian, respectively.

P0w
Ls0 = .g ( N )
P0
P1w
L1s = .g ( N )
P1
w0
w1

f (N )

N 0 N1 N
e
P .g ( N )
1

B P0e .g ( N )
W1 D C

W0
P1. f ( N )
P0 . f ( N )

N 0 N1 N
Y (N )
Y1
Y0

65
 N 0 N1 N
−
Y = AS = Y + α ( P − P e )

P1
P0

Y0 Y1 Y

Fig 1.22: Labour market Equilibrium and AS, the New (general) Keynesian case

EXCERSISE 1.5:
(1) Suppose the production function and
labour supply are given y = y ( L, K ) = 800 L −12 .5L2 ; and Ls = 380 L + 2.5L2 ,
respectively. Further, assume that the price levels in period zero; P0 =1 and it has
doubled in period 1; that is P1 =1 . Given this information,
A) Calculate the equilibrium
employment ( L ), output ( y ), money (nominal) wage and real wage for the
extreme Classical, extreme Keynesian, and New Keynesian case in real and
nominal term.
B) Discuss the reasons why the
results you have obtained in question 1A above happened to be and show the
results graphically.
C) Derive the AS curve for the
three cases and show the results in 1A graphically.

(2) Using the labour market equilibrium,

equation (9) and equation (10) and assuming expectations are perfect initially and set
the price index P = 1
A) Derive the slope of Aggregate Supply curve algebraically
B) Evaluate whether the slope of the Aggregate Supply (AS) curve of extreme
Classical, extreme Keynesian, and new Keynesian are positive, negative or
zero
C) Show also the values of dN / dP for the three cases is similar to that of dy / dP

66
 CHAPTER 2: MACROECONOMICS DYNAMICS

2.1 Economic growth and technical growth

2.1.1 Economic growth:
Economic growth is an expansion of an economy’s productive potentials over a long
period of time. It is concerned with the long term sustainable trend rise in output than short
term fluctuation. In other words, the dynamic behavior of macroeconomics is concerned
with the rate of change of key economic variables overtime.

Thus, economic growth is thus expressed as the change in income or output ( Y ) level
overtime as follows:
∧

Economic growth = Y = ∂Y . 1 ------------------------------------------- (2.1)

Y ∂t Y
∧
Where, Y read as Y hat is the time deviation or change in the level of output or GDP and
t is time. That is, Y∧ = ∂Y / ∂t or simply ∆Y = Yt −Yt −1 . To express growth rate in
percentage we should multiply it by 100.

For instance, according to MoFED (2006) macro data real GDP in Ethiopia in 2003 and
2004 fiscal year were Birr 16,941.5 and 18,900.9 million respectively. Thus, economic
growth in 2004 was:
∧
Y ∂Y 1 (Y2004 − Y2003 )  18,900 .9 − 16,941 .5  1959 .4
= . = = = x100 = 11 .6%
Y ∂t Y Y2003  16,941 .5  16,941 .5

From the above example, the value of equation (2.1) is 0.115657. But when multiplied by
100 and rounded to one decimal digit it becomes 11.6%.

67
 The above simple analysis raises the question what are the potential sources of economic
growth? The neo-classical growth model, developed by Solow in 1956, postulates that
growth rate is derived by the rate of growth of the labour force and technical growth.
However, the endogenous growth model, which is alternative classification of technical
progress and considers the principles of to the neo-classical growth model, suggests that
savings/investment are an important factor in determining the level of economic growth.

2.1.2 Technical progress (Total factor productivity)

The study of the potential sources of economic growth stems from the aggregate
production function which links factor inputs to output for a given level of technology.
That is

Y = AF ( K , N ) ----------------------------------------------------------- (2.2a)

To keep the analysis simple consider a Cobb-Douglas constant return-to-scale (CRS)

production function

Y = AK α N 1−α ----------------------------------------------------------- (2.2b)

Where, Y is the level of output; A represents the state of technology; and K and N are
capital and labour inputs. In equation (2.2b), α is the share of capital in output and 1 −α
the share of labour input in output.

Differentiation of (2.2b) with respect time gives the rate of change of output overtime,
which can be written as

∂Y 1 ∂A 1 ∂K 1 ∂N 1
= +α + (1 −α) ------------------------------------ (2.3a)
∂t Y ∂t A ∂t K ∂t N

Or using the hat notation as

∧ ∧ ∧ ∧
Y A K N
= + α + (1 − α ) -----------------------------------------------------
Y A K N
(2.3b)

Thus, the rate of growth of out put or simply economic growth is identically equal to the
∧
rate of change of technology (technical progress A / A ), called total factor productivity
(TFP) plus the rate of growth of each factor inputs multiplied by their respective shares in
total output (that is, α for capital and 1 − α for labour). Equation (2.3b) is called the
growth accounting.

Technical progress or total factor productivity is the amount by which output would
increase as a result of improvement in methods of production with all factor inputs
unchanged and is distinct from labour productivity10.
10
Labour productivity is the ratio of output to labour input Y / N = y . Labour productivity may grow because of
the improvement in capital inputs per worker, K / N = k

68
 The problem with equation (2.3b) is that the growth of total factor productivity (TFP)
cannot be measured directly. Solow (1957) derived an estimate of TFP by inverting
equation (2.3b) and driving TFP as a residual as shown in equation (2.4) below. This
measure of TFP is therefore sometimes referred to as the Solow residual. Due to his
inability to describe why this TFP occurred and its growth process Solow called it simply
‘Manna from heaven’.
∧ ∧ ∧ ∧
A Y K N
TFP = = − α − (1 − α ) ---------------------------------------- (2.4)
A Y K N

To understand the applicability of equation (2.4) let us use a simple example. Suppose
capitals share of income ( α ) is 0.3 and that of labour ( 1 − α ) 0.7. Then if the labour force
∧ ∧
grows (or N/ N ) by 1 percent, the capital stock grows (or K/ K ) at 3 percent with the total
factor productivity of 1 percent, then the growth rate of output must be, by accounting
identity of equation (2.3) be 2.6 percent. More examples are shown in table 2.1 below.
Table 2.1: Growth accounting for selected countries
Countries Growth rate Growth rate contribution of Growth rate of
of GDP ( Capital Labour TFP Capital Labour GDP per
∧ ∧ ∧ ∧ ( ∧ ∧
Y/Y ) α( K / K ) (1 − α) N/ N ( A/ A ) ∧
( N/ N worker( Y/ N
K/ K ) )
)
USA 3.1 0.9 1.2 1.1 2.7 1.8 2.2
Japan 3.73 2.28 0.67 0.78 6.84 1.005 2.725
Germany 1.8 1.28 -0.49 1.01 3.84 -0.735 2.535
Source: Summer and Heston (1991) for USA and Maddison (1991) for others, and own calculations for the last
three columns
Note: The figures in the table are for the period 1960-1990 for the USA and 1973-1987 for other countries.
: The value of α = 1 / 3 is used in the calculation

Given the value of α = 1 / 3 , how the growth rates of capital and labour and GDP per
worker, shown in the last three columns, are calculated is illustrated as follows. Example,
for USA the growth rate of:
(3) The growth rate of capital is
calculated from the growth contribution of capital = 0.9. That is
∧
α( K / K ) = 0.9
∧
1 / 3( K / K ) = 0.9
∧
K / K = 0.9(3) = 2.7
(4) The growth rate of labour:
∧
(1 − α) N / N = 1.2
∧
(1 −1 / 3) N / N = 1.2
∧
2 / 3( N / N ) = 1.2

69
 ∧
N / N = (3 * 1.2) / 2 = 1.8
(5) The growth rate of GDP is simply the
growth rate of GDP less the growth contribution of labour. That is,
∧ ∧ ∧
y = Y/ Y − N/ N
∧
y = 3.1 −1.8 = 1.3

2.2 Stylized facts

1. There are significant variations in the per capita income across countries. For example,
Jones (2000, page 56) documented that a typical person in the United State earns the
annual income of a typical person in Ethiopia in less than ten days.
2. The rate of economic growth varies across countries. Between 1960-1990 average
growth of the USA and Tiger countries was 1.4% and 5%, respectively while some
African countries had negative economic growth.
3. Growth rate of many countries is not constant or sustainable but it fluctuates.
4. A country’s position in the world is not fixed. That is countries which were poor in the
past are now growing fast and catching rich countries. China which grows by double
digits over the past 20 years is the best example in this regards. Some contraries whose
economic growth and per capita income were relatively better than others in the 1970’s
are now growing slower and lagging behind their counter parts. For example,
Ethiopia’s economic growth and per capita income which were better than that of
South Korea in 1975 are now not only incomparable to the economic growth and per
capita income of South Korea but also is one of the least in the glob11.
5. Economic growth and investment in human capital or education are highly correlated
due to the later contribution in ensuring social equity and improving labour
productivity.
6. Both skilled and unskilled workers are migrating from poor countries to rich countries,
which is contradictory to what economic theory postulated regarding the flow of
resources. Economic theory postulate resources should flow from where they are
abundant to where they are scarce. Thus, though the migration of unskilled labour
from developing countries to developed countries is consistent with what economic
theory postulate the migration of skill skilled workers or brain drain of developing
countries against economic theory.

2.3 Growth models

Theories of economic growth are concerned with the rate of long run equilibrium growth that
is with the rate of growth of output that yields full employment of labour and capital. Rising
unemployment of labour would, by definition, violate the full employment assumption, and it
would probably would be accompanied by the deficient demand and falling prices. On the
other hand, under utilization of capital stock would drive profit and investment incentives
down, reducing investment and the demand for output.

2.3.1 The Solow Model

The neo-classical Solow growth model is based on the following six assumptions.

11
Jones (2000), “Introduction to Economic Growth” explains this fact adequately

70
1) Because the economy is assumed to be closed and there is no public sector, in
equilibrium investment will be equal to savings. That is,
S = I ------------------------------------------------------------------------- (1)
2) Savings are assumed to be proportional to income. That is,
S = sY ----------------------------------------------------------------------- (2)
Where s the MPS and assumed to be 0 < s < 1
∧
3) It is assumed that no technological progress, such that A = 0 in equation (2.4)
∧ dK
4) The change in capital stock overtime K is and is equal to gross investment, I
dt
less depreciation ( d ) times capital stock ( dK ). That is,
∧
K = I − dK ------------------------------------------------------------------ (3)
5) The labour force, N is assumed to grow at a constant (equal to population growth),
exogenous rate of n . That is, the rate of growth of labour force is
∧
∂N / N N 12
= = n ------------------------------------------------------------ (4)
∂t N
6) The neo-classical assume a constant rate to scale (CRS) production function such that
Y = F ( N , K ) .CRS means that multiplying all factor inputs by, z will give an increase in
output by z . Formally,

zY = F ( zK , zN ) ----------------------------------------------------------- (5)

In other word, if we double labour and capital inputs are doubled, then output will also
double. With these assumptions, the production function can be written in per capita
income form. To do this let z = 1 / N , then the production function becomes
Y K 
= F  ,1
N N 
y = F (k ) ------------------------------------------------------------------ (6)

In equation (6) lower-case letters denote variables measured relative to population.

Hence, y is output per head/worker, Y / N , and capital per head/worker is k = K / N .
Hence, the equation is per head production function, in general form, which depends only
on capital per head/worker- k = K / N . As a result increasing both K and N by the
same proportion will not change y = Y / N . Thus, there is no gain in output per head from
increasing both labour and capital as long as K / N ratio, k , is the same because of the
assumption that the production function exhibits CRS. The per capita production function is
illustrated in Figure 2.1.

Y
y= y = f (k )
N

12
If n = 0.01 , then the labour force and population are growing at one percent per year.

71
 K
k =
N
Fig 2.1: The per capita production function

The marginal productivity of increasing the capital-labour ratio is positive but diminishing.
That is, the first order derivative is positive or f k (k ) > 0 and the second order derivative is
negative or f kk = ( k ) < 0 . If the production function is assumed to take the Cobb-Douglas
form as in equation (1), then there are CRS since the factor shares sum to unity. In per
capita term the Cobb-Douglas form is written as
Y = AK α L1−α
AK α N 1−α AK α
y= = α
= Ak α ---------------------------------------------- (7)
N N

This production equation is sometimes called the AK model. The marginal productivity of
k is given as
∂y
MPk = = αAk α −1 > 0
∂k
And the second order derivative;
∂MPk ∂2 y
= 2 = (α − 1)αAk α −2 < 0
∂k ∂k

Which is negative because α < 0 and hence (α −1) < 0 . This shows that the MPk is
decreasing with additions to k ; that is the production function is concave downward as
shown in figure 2.2.

From the per capita production function, equation (6), it should be apparent that the growth
rate of GDP per capita is going to be determined by the growth rate of capital per head-
k , which is written as (using assumption 5)

K
k= ⇒ log k = log K − log N
N
∧ ∧ ∧
k K N
⇒ = − --------------------------------------------------------------- (8a)
k K N

Recall also
y = k α ⇒ log y ⇒ α log k
∧ ∧
y k
⇒ = α --------------------------------------------------------- (8b)
y k

Using the assumption that growth over time of capital stock is equal to investment less
depreciation, equation (3); that savings equal to investment, equation (1), and that savings
are directly related to income from equation (2), and substituting into equation (8a)

72
 ∧
k I − dK
= − n , equation (3) and (4) substituted into equation (8a)
k K
∧
k sY
= − ( d + n) , equation (1) then equation (2) substituted. Multiplying both sides by k
k K
gives
∧ sY
k =k − ( n + d ) k , we know k = K / N . Substituting this in the first tern for k we
K
get
∧ K sY
k= − ( n + d )k , this can be rearranged as
N K
∧ K sY
k= − ( n + d )k , we know that K / K cancels out and finally substituting y = Y / N ,
K N
∧
k = sy − (n + d )k -------------------------------------------------------- (9)

Equation (9) is the fundamental dynamic equation for the neo-classical SOLOW
GROWTH MODEL and known as the capital accumulation equation in per worker terms.
The equation says that the change in capital per worker each period is determined by three
∧ ∧
terms: investment per worker, sy increases k ; depreciation per worker dk reduces k , and
∧
change in labour force, nk which reduces capital per worker k .

∧
In the steady state or equilibrium, when k = 0 , equation (9) will be

sy = ( d + n) k -------------------------------------------------- (10a)
Equation (10a) says that the proportion of income per head/worker that is saved must be
equal to the rate of growth of capital per head. In other words, to maintain continuous full
employment, savings per head must be sufficient to replace the worn-out machines dk
and to purchase new machinery in sufficient quantity to keep the growing of population
employed nk .

Dividing both sides of equation (10) by sk we get;

y f (k ) n + α
= = ----------------------------------------------------- (10b)
k k s

The two rays from the origin are ( n +δ)k and (n + δ ) / s . The first and second rays are
shown in the last term of equation (10a) and (10b) respectively. The Solow model is
illustrated graphically as follows.

73
The flatter ray ( n +δ)k represents the saving/investment requirement of the model or the
amount of new investment per person required to keep the amount of capital per worker
(k ) constant-both depreciation and the growing of workforce tend to reduce the amount
of capital per person in the economy. By coincidence the difference between the two
∧
curves is the change in the amount of capital per person ( k ) .In the lower panel of the
∧
−
figure the dynamics of adjustment are shown such that at any level of k , other than , the
k
∧
−
model automatically converges back to .
k

 n +δ 
 
 s 
y

y = f (k )
y0
( n +δ ) k
Consumption
sy E sy = sf ( k ) = sk α

s0
i0

∧
−
k* k ** k
k
∧
k

∧
−
k *
k ** k
k

Fig 2.2: Solow growth model equilibrium

To consider a specific example, suppose an economy has an initial capital-labour ratio of

k * today as shown in Figure 2.2 above. What happens overtime? At k * the amount of
savings/investment per worker or per head of the population, s1 exceeds the amount of
savings/investment required to keep capital per worker (k ) constant; that is to replace the
worn-out machines and fully employ the workforce. Thus, capital deepening occurs or
capital-labour ratio (k ) will increase over time. Indeed, this capital deepening will

74
 ∧
∧
continue until k reaches −
, at which sy = (δ + n)k , so that k = 0 . At this point the
k
amount of capital per worker remains constant, and we call such a point a steady state.
Similarly when the economy starts at an initial capital-labour ratio of k ** the amount of
new investment coming from saving is insufficient to keep the growing labour force fully
employed. In other words, the amount of investment per worker provided by the economy
∧
is less than the amount needed to keep capital per worker (k ) constant; the term k < 0 is
negative, capital widening is occurring. Therefore, since population growth is at a rate of
n , the capital stock must increase be growing at the rate of n and hence the economy as a
whole is growing at rate n .

The model can now be used to understand determinants of economic growth. In this
section we will examine what happens to the per capita income in an economy that begins
in steady state but then experiences a “shock”. The two shocks we will consider are the
increase in saving rate and the increase in the rate of population growth.

Comparative statistics
1) The increase in saving rate
Consider the economy has arrived at its steady state value of output per worker. Now
suppose that consumers in an economy decide to increase the saving/investment rate
permanently from s1 to s2 . An increasing in saving rate can come from a cut in the implicit
tax rate (inflation) on saving through a change in the tests of individuals between
consumption and saving. What happen to k and y ?

The increase in saving rate shifts the saving line upward from s1 y to s2 y in figure 2.3. At
the current value of capital stock k * , saving per worker now exceeds the amount of
investment required to keep the capital per worker constant, and therefore the economy
begins capital deepening again. This capital deepening continues until s1 y = (n + δ )k and
the capital stock per worker reaches a higher value indicated by k ** . From the production
function, we know that this higher level of capital per worker will be associated with higher
per capita income. That is, the level of income per head rises from y0 to y1 . The economy is
now richer than it was before.
y

y1 y = f (k )
y0 ( n +δ ) k
B s1 y = s1 f (k )

E s0 y = s0 f (k )

75
 k* k **

Fig 2.3: An increase in investment rate

2. The increase in population growth

Consider an alternative exercise. Suppose the economy has reached and its steady state, but
then due to immigration, for example, the population growth rate of the economy rises
from n to n1 . Due to population growth, the ( n +δ) k curve rotates up to the left to a new
( n1 + δ ) k . At the current value of capital stock k * , saving per worker is now no longer
high enough to keep the capital per worker constant in the face of rising population.
Therefore, the capital per worker began to fall until the point at which s0 y = (n1 + δ )k
indicated by k ** . The economy has less capital per worker than it begins, and is therefore
poorer. The per capita income is ultimately lower after the increase in population growth in
this example.

y y = f (k )
y1 ( n1 + δ ) k

y0 (n +δ)k

E s0 y = s0 f (k )
B

k ** k*
Fig 2.4: An increase in the population growth rate

2.3.3. Endogenous Growth Models

The alternative model of growth process seeks to explain why the rich gets richer, that is why the
supply of capital does not flow from the rich countries to the poorer countries where the marginal
productivity of capital is higher. The reason must be that the marginal productivity of capital does
not in the rich countries despite the rising capital-labour ratio. The new growth theory, therefore,
is ultimately concerned with moving the assumption of diminishing returns to reproducible
factors of production, such as capital. This is achieved by the endogenous technical progress. In
the neo-classical model technical progress drives economic growth, although it does not offer any
explanation for technical progress. In other words, g , the labour-augmenting technical progress
is exogenous: in a common phrase, technology is like “manna from heaven”.

The endogenous growth theories, on the other hand, postulate that the extent of labour-
augmenting technical progress is endogenous in the model, depending on the capital-labour ratio

76
to generate sustained growth in per capita income. This is to say better technology is produced as
a by product of capital investment.

To be specific, we must follow Solow and introduce technological progress, which is labour-
augmenting or “Harrod - neutral”. As was in the case with Solow model, there are two main
elements in the Romer (1990) model of endogenous technological change: an equation describing
the production function and a set of equation describing how the inputs for production evolve
over time. The main equation is similar to the equations for Solow, with one important
difference. The aggregate production function in the Romer model describes how the capital
stock, K , and labour, LY , combine to produce output, Y using the stock of idea or human
capital, A .
Y = K α ( ALY )1−α ----------------------------------------------------------- (1)

For a given level of technology, A , the production function in equation (1) exhibits a constant
return to scale in capital, K , and labour, LY . However, when we recognize that ideas ( A) are
also input into production, then there are increasing returns.

The accumulation equations for capital and labour are identical to those in Solow model. Capital
accumulates as people in the economy forgo consumption in some given rate s and depreciates
at the exogenous rate d .
∧
K = sK Y − dK

Labour grows exponentially at some constant and exogenous rate, n which is equivalent to
population growth. Using the notation, L , for labour than what we have used earlier N
∧
L
=n
L

∧
In the Romer model, growth in A is endogenized. According to him, A(t ) is the stock of
knowledge or number of ideas that have been invented over the course of history until time t .
∧ ∧
Then, A is the number of new ideas produced at any given period of time. In short, A is equal
to the number of people attempting to discover new ideas, LA multiplied by the rate at which
∧
they discover new ideas ω . That is, the production function for new ideas can be written as
∧ −
A = ω LA ------------------------------------------------------------------ (2)

Labour is used either to produce new idea or produce output, so the economy faces the following
resource constraint:
L = LY + LA

To proceed with the endogenous growth model, emphasizing on the economics of idea or human
capital we must make the following assumptions.

77
 ∧
(1) The rate at which researchers discover new ideas ( ω ) may depend on the
stock of ideas that have already been invented.

For example, perhaps the invention of ideas in the past (that is ω ) raises the productivity of
∧
human capital or researchers in the present. In this case, ωwould be an increasing function of
A . The discovery of calculus, the invention of computer and laser, and the development of
integrated circuits are examples of idea that have enhanced the productivity of the later
researchers. On the other hand, the most obvious ideas discovered first and subsequent ideas
∧
become increasingly difficult to discover. In this case, ω would be a decreasing function of A .
∧
This reasoning suggest modeling, the rate at which new ideas are produced ( ω) as
∧
ω = ωAβ ---------------------------------------------------------------- (3)

Where, ω and βare constant. In equation (3), if β > 0 it indicates that the productivity of
research increases with the stock of ideas that have already been discovered or simply a positive
knowledge spillover. This also most popularly known as the “standing on shoulders” effect13;
β < 0 corresponds to the difficulty of discovering subsequent ideas. Finally, β = 0 indicates that
the tendency for the most obvious ideas to be discovered first exactly offsets the fact that the old
ideas facilitate the discovery of new ideas- i.e., the productivity of research is independent of the
stock of ideas.

(2) On the other hand, the average productivity of researchers depends on the
number of people searching for new ideas at ant point in time.

For example, perhaps duplication of efforts is more likely when there are more persons engaged
λ
in research. One way of modeling this possibility is to suppose that it is really LA , where λ is
some parameter between 0 and 1, rather than LA that enters in the production function for new
ideas. Thus, focusing on equation (2) and (3) suggests focusing on the following GENERAL
PRODUCTION FUNCTION FOR IDEA.
∧
λ
A = ω LA Aβ ----------------------------------------------------------------- (4)

In equation (4), for example, if λ < 1 it reflects an externality associated with duplication; some of
the ideas created by an individual researcher may not be new to the economy as a whole of
“stepping the toes” effect.

Growth in the Romer model

What is thus the growth rate in the endogenous model along the balanced growth path? Provided
that a constant proportion of the population is employed producing ideas, the model follows the
neo-classical model predicting that all per capita growth is due to technological progress. Letting
lower-case letters denote per capita variables, it is easy to show that
13
In this regards, Isaac Newton who has benefited from the knowledge created by previous scientists such as
Kepler, in developing his theory of gravitational force has recognized in his famous statement, “If I look
farther than others, it is because I was standing on the shoulders of the giants”.

78
 g y = gk = g A

That is, per capita output, the capital-labour ratio, and the stock of ideas must all grow at the same
rate along the balanced growth path. It implies that, if there is no technological progress, there is
no growth. Therefore, the important question is, “What is the rate of technological progress along
the balanced growth pats?” The answer to this equation is found by rewriting equation the
production (4). Dividing both sides of equation (4) by A yields
.
∧
A λ Aβ or
.
= ϖLA .
A A
λ
= ϖLA Aβ −1 or
.
∧
λ
A LA --------------------------------------------------------------- (5)
.
=ϖ .
1− β
A A
∧

Along a balanced growth path, A ≡ g A is constant. But this growth rate will be constant if and
A
only if the numerator and the denominator of the right hand side of equation (5) grow at the same
rate. Taking logs and derivatives of both sides of this equation
∧ ∧
L A
0=λ − (1 − β ) -------------------------------------------- (6)
LA A

Along a balanced growth path, the growth rate of the number of researchers must be equal to the
growth rate of the population – if it were higher, the number of researchers would eventually
∧
exceed the population, which is impossible. That is, L A / LA = n . Substituting this into equation
(6) yields
λn = (1 − β ) g A
λn
gA = -------------------------------------------- (7)
(1 − β)

Thus the long run growth rate of this economy is determined by the parameters of the production
function for ideas and the rate of growth of researchers, which is ultimately given by the
population growth rate.

Comparative static: A permanent increase in the R&D share

What happens to the advanced economies of the world if the share of the population searching for
new ideas increases permanently? For example, suppose there is a government subsidy for R&D
that increases the fraction of labour force doing research.

Notice that technological progress in the model can be analyzed by itself – it does not depend on
capital or output, but only on the labour force and share of the population devoted to research.

79
Now consider what happens if the share of the population engaged in research increases
permanently. To simplify things slightly, let’s assume that λ = 1 and β = 0 again; none of the
results are qualitatively affected by this assumption. It is helpful to write equation (5) as
.
∧
A sR L --------------------------------------------------------- (8)
.
=ϖ .
A A

Where, sR is defined as the share of the population engaged in R&D – i.e., LA = sR L . Figure 2.5
shows that what happens to technological progress when sR increases permanently to s′R ,
assuming the economy begins in steady state. In steady state, the economy grows along a balanced
growth path at the rate of technological progress, g A , which happens to equal the rate of
population growth under our simplifying assumptions. The ratio LA / L is therefore equal to g A / ϖ
. Suppose the increase in sR occurs at time t = 0 with a population of L0 , the number of
researchers increases as sR increases so that the ratio of LA / L jumps to a higher level. The
additional researchers produce an increased number of new ideas so the growth rate of technology
is also higher at this point. This situation corresponds to the point labeled “ X ” in the figure.

∧ ∧
A/ A A/ A = ϖLA / A

gA = n

g A /ϖ s′R L0 / A0 LA / L

Fig 2.5: Technological progress: An increase in the R&D share

∧
At X , technological progress A/ A exceeds population growth n so that LA / L declines
overtime, as indicated by the arrows. As this ratio declines, the rate of technological change
gradually falls also, until the economy returns to the balanced growth path where g A = n .
Therefore, a permanent increase in the share of the population devoted to research raises the rate of
technological progress temporarily, but not in the long run.

80
 CHAPTER 3: RECENT DEVELOPMENTS IN MACROECONOMICS

3.1 Rational Expectation (Ratex hypothesis)

Before discussing the rational expectations (Ratex hypothesis), it is essential to
understand the meaning of static and adaptive expectations used in macroeconomics and
how these expectations were formed before the Ratex hypothesis was developed.

Definition: Expectations are forecasts or predications by economic agents regarding the

uncertain economic variables which are relevant to their decisions. They are based on past
trends as well as current information and experience.

People make expectations about economic variables; say price level in three ways.

a) STATIC (NAÏVE) EXPECTATIONS:

What happened in the past or yesterday will happen today and in future. Therefore, since
inflation tomorrow will be the same as today and yesterday (that is, price level in period
Pt + 2 = Pt +1 = Pt –1 or Pt0) there will be no change in equilibrium real wageworkers receive
(w0), level of employment (N0), and income (y0).

b) ADAPTIVE EXPECTATIONS HYPOTHESIS:

The pioneering work was done by Cagan14 in 1956 and Nerlove15 in 1957. According to
adaptive expectations hypothesis, economic agents expect the future to be essentially a
continuation of the past. They expect the future values of economic variables like prices,
incomes, wage rates, etc. to be an average of past values and to change very slowly. The
economic agents make the expected values of these variables equal to weighted average of
their present and past values. They revise their expectations in accordance with the last
forecasting error. Errors resulting from past behavior represent an important source of
information in forming future expectations. But such expectations are based on the
assumption that the economic agents expect them to change very little.

In short, adaptive expectations say what will happen tomorrow (say to price) is a function
of what has happened yesterday or in the past and some adjustments made today from the
errors of last period. For instance, peoples’ expectation made last year about this year
price level is given as,
Pt e =t −1 Pt = Pt −1 +α(t −2 Pt −1 − Pt −1 ) ------------------------------- (3.1)

Equation (3.1) says that the expected price level ( Pt ) in year t ; that is current period/this
e

year- but expectations are made in the previous (last) year ( t −1 Pt ) is equal to inflation or
price level in last year ( Pt −1 ) plus adjustments made ( α ) about the previous year’s
mistake in forecasting the previous year or a year before( t −2 Pt −1 ) and to price in that
14
Cagan, P. (1956), “The Monetary Dynamics of Hyperinflation”, in M. Friedman (ed), studies in the
Quantity theory of Money.
15
Nerlove, M. (1957), “Adaptive Expectations and Cobweb Phenomenon”, Quarterly Journal of Economics,
May

81
 year ( Pt −1 ). Then, expectations made two years before about last year expected price
level is
t −2 Pt −1 = Pt −2 +α( t −3 Pt −2 − Pt −2 ) -------------------------------- (3.2)

Substituting equation (3.2) into (3.1) for t −2 Pt −1 gives

t −1 Pt = Pt −1 +α[ Pt −2 +α( t −3 Pt −2 − Pt −2 ) − Pt −1 ] , rearranging this we

have
= Pt −1 − αPt −1 + αPt + 2 + α 2t − 3 Pt − 2 − α 2 Pt − 2
= (1 − α ) Pt −1 + α (1 − α ) Pt − 2 + α 2t − 3 Pt − 2 ----------------------- (3.3)
Equation (3.3) simply says that the expected price level depends on the past trend of price
or is the weighted average of past price levels, but the weights are ordered in such a way
that more recent prices have larger effect than more distant ones. As a result, adaptive
expectation is also sometimes called the Partial Adjustment Principle.

c) RATIONAL EXPECTATIONS HYPOTHESIS:

The idea of rational expectations was first put forth by John Muth16 in 1961 who borrowed
the concept from engineering literature. His model dealt mainly with modeling price
movements in markets. By assuming economic agents optimize and use all information
available efficiently when forming expectations about the future, he was able to construct a
theory of expectations in which consumers’ and producers’ responses to expected price
changes depending on their responses to actual price changes. Muth pointed out that
certain expectations are rational in the sense that expectations and events differ only by
a random forecast error.

Muth’s notion of rational expectations related to micro-economics. The hypothesis did not
convince many economists and lay dormant for ten years. It was in the early 1970’s that
Robert Lucas, Thomas Sargent, and Neil Wallace applied to problems in macro-economics.

Basis properties of the rational expectations hypothesis

The Ratex hypothesis holds that economic agents form expectations of the future value of
economic variables like prices, incomes, wages, etc., by using all available and relevant17
economic information to them in an intelligent fashion. This information includes the
relationship governing economic variables, particularly monetary and fiscal policies of the
government. That is, economic agents will incorporate all “news” as it comes in. News
would come from personal experience in buying and selling, from private contact or from
newspapers and from one’s own past prediction of errors. The last resource is especially
important for it brings the difference between the rational and adaptive expectations. Thus,
the rational expectations assume that economic agents have full and accurate information
about the future economic events.

Thus, with rational expectation the expected error is zero and the errors are not linked in
any way by a spiral correlation. This is an implication for the unbiased ness of rational
16
John F. Muth (1961), “Rational Expectations and the Theory of Price Movements”, Econometrica, July
17
It is important to recognize that this does not imply that consumers or firms have “perfect foresight” or
that their expectations are always correct.

82
 expectations. That is, t −1 ( Pt +1 ) =t −1 Pt +1 t – 1. The implication is that the expectation made
in period t −1 , of the prediction that will be made at time t about Pt +1 is equal to the
actual prediction at t -1 of Pt + 1. In short, the expected forecast equals current forecast. This
is known as the law of ITERATED EXPECTATION. Rational expectation is also called
Model Consistence because it is as if everyone knows the model and uses this knowledge
fully.

The conclusion based on equation (3.3) is that, if α = 0 , then t −1 Pt = Pt −1 which implies

static (naive) expectation; if α = 1 , then t −1 Pt =t −3 Pt −2 , which implies adjustment are
perfect or rational.

CHAPTER 4: MACROECONOMICS THEORIES AND AFRICAN ECONOMIES

4.1 Introduction: The Classical and Structuralist School

83
Two schools of thoughts emerged to explain the applicability of the conventional
macroeconomic models in LDCs in general and in Africa in particular. These are the
orthodox approach and the structuralist view

4.1.1 The Orthodox approach (Classical and monetarists)

These schools of thoughts examine the short and long term behavior of the economy in
Africa. They argued that the problem in developing countries is caused by misallocation of
resources. This is mainly due to the huge hand of the government in the economy.

The solution to long run growth problems is getting the price right or enhancing market
mechanisms to address misallocation of resources. That is, pursuing non interventionist
domestic policies or reducing government intervention and the huge hand of the state in the
market so as to avoid market distortions and leaving the market to equilibrate demand and
supply. In other hand, following sound market economy and adhering strictly to the market
economy principles are vital for sustainable long run growth. In the short run however,
solving problems of inflation and balance of payment imbalances through tight monetary
and fiscal policies, devaluation of domestic currency to become competitive in international
trade and increase revenue export and reduce BP problem, and rise interest rate to increase
savings are the optimal solutions.

4.1.2 The structuralist view:

As the name implies structural rigidities within the domestic economy are the main factors
for low aggregate demand in LDCs. This school of thought is divided into the early and
recent.

(A) The early structuralist view:

This school of thought was dominant in 1960’s and 1970’5. Exports of developing countries
consist more of primary products. As a result the products have low income and price
elasticity of demand compared to that of manufacturing outputs of developed countries.
This in turn leads to continuous deterioration of terms of trade (TOT). That is when they
produce more, the price of their exports declined significantly.

The solution proposed by the early structuralist is moving to the production of industrial
goods under the protection of infant domestic industries to replace imported goods from
abroad in the long run. This argument is simply referred as the import substitution
argument. According to the early structural school thinkers this can be facilitated among
others through high tariff barriers on imported goods, providing subsidies of various forms,
and improving access to credit and foreign exchange.

(B) The recent structuralist view:

Taylor was the most notable and influential leader recent structuralist. The recent
structuralist focuses mainly on the short run stabilization or adjustment policies. They
questioned the validity of the orthodox policy prescriptions of tight monetary and fiscal
policies and devaluation to LDC economies and argued that monetary policy or increase in
money supply is only accommodative and not the cause of high inflation. According to
them, prices and wages are not flexible and the source of inflation in LDCs is slow

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productivity growth in agricultural, the backbone of the majority of African countries, not
money supply.

Furthermore, they argued that the main causes of slow agricultural productivity and also
that influence monetary policy in LDCs are poor land tenure system, administrative prices,
and wage indexation. Consequently, given that working capital and imported inputs play a
significant role in terms of addressing structural rigidities and limited substitution
possibilities in production a policy package combined devaluation with tight monetary and
fiscal policies will lead to stagflation. To the recent structuralists, if prices and wages are
rigid monetary or fiscal policy becomes effective in the short-run. Hence, the solutions are
some degree of government intervention in the market is necessary to eliminate structural
problems/rigidities in production before applying the standard orthodox prescriptions. This
includes undertaking interventions related to export promotion and export diversification;
such as the provision of subsidy, tax-holiday, information, etc., to exporters

4.2 Basic Features of African Economies

The distinguishing macroeconomic features of African economy include more openness to
trade in both commercial and assets; the nature of the financial markets, different attributes
of both short and long run fluctuations; the nature of fiscal deficits; determinants of the
private sector credit behavioral function (biasness or preferential treatments of public sector
enterprises for credit); and the stabilization policy regimes.

1) Openness to trade
Relative to developed countries, African economy tend to be more open and to have little
control over the price of products they exports and import. The standard measures of degree
of openness are looking into the ratio of exports plus import to GDP and the tariff structure.
The implication of these characteristics is that:
(a) The standard open macro economy policies may not hold at all or are irrelevant
(b) Given their share in the world trade and composition of their exports they do not have
control over the prices of their exports and imports have huge policy implication. That
is, first they export primary products, which are not demand determined but supply
determined. Second, they are small relative to MDC and DC. Therefore, the standard
open economy model, which assumes endogenous TOT, has little use in explaining
their macroeconomic behavior.

2) The exchange rate regime

In contrast to MDC the vast majority of African economies have exchange rates either
fixed or pegged to a foreign country, which leads in most cases to exchange rate retention
or control. In many cases the actual exchange rate deviates from the equilibrium exchange
rate. Recently many African countries have adopted flexible exchange rate but not market
determined. That is they are administered rather than auctioned or demand and supply
determined. The Ethiopian exchange rate regime is called managed floating, which is
between the two extremes - fixed and flexible exchange rates;. Since it is only the financial
institutions who buy the foreign currency through the bi-weekly inter-banks auction
market, this indicates some degree of government influences over the exchange rate.

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 3) Capital inputs
Almost all African economies are net importers of capital (both physical and financial
capital). Therefore, dependence on foreign market is an important issue.

4) The role of the state

The state plays an important role in the production and distribution of goods and services
in LDCs. In MDCs, however, the private sector has the larger share in the economy as
compare to the public sector. The policy implications are:

(A) Imported intermediate goods play important role in the aggregate production function.
(B) An increase in cost of intermediate goods affect the exchange rate and the exchange
rate affects AS because we may import more or less unlike the MDCs where the
exchange rate does not enter into AS because their exchange rate is floating/flexible/
and do not import much intermediate goods.

5) The financial sector

The financial sector in LDCs is weak and inefficient. It is characterized by the prevalence
of rudimentary/underdeveloped financial market and financial repression. That is, the
financial sector is dominated by commercial banks with little or no secondary stock and
security markets, which implies allocation inefficiencies. The two most important
implication of underdeveloped financial sector in LDCs are financial dualism and financial
repression:

(A) Financial dualism: It is the coexistence of organized and

unorganized/traditional money markets in LDCs.
The organized money market consists of commercial banks and other financial
intermediaries, which lend short-term credit at low interest rates to the modern business
sectors consisting of big companies, large scale manufacturing enterprises, and the
government. On the other hand, the unorganized money market consisting of non-
institutional money lenders, such as village money lenders, traders, shopkeepers, or the
combination of some of them, which charge higher interest rates on loans. The main reason
is that there is real shortage of savings in the traditional sector as substantial amount of
savings is horded in gold and jewelry. As a result,

• not only a significant part of financial transaction takes place control and direct
policy reach of the central banks but also there is interest rate differential
• whatever monetary policy is to be practiced must be affected by other than open
market operation. Since the government debt with its artificially low interest rate is not sold
and bought in free market the monetary authorities/central bank cannot affect the monetary
base ( D + R ). It is rather determined by the past and current government deficits and trade
balances.

(B) Financial repression/ compartmentalization: It is a policy of the state in terms of

financial sector where nominal interest rate ( r ) that the commercial banks pay on
their deposits and charge for their loan are kept low/hold down without taking into
account the demand and supply.

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Credits are given to public enterprises on preference basis than on demand basis; implying
the private sector does not have adequate access to credit as the public enterprises. The
implication of financial repression is that the transmission mechanism and effectiveness of
monetary policy- that is as money supply increases interest rate declines, investment
increases, and hence output grows does no work in LDCs for interest rate is fixed.

6) Government budget
Most countries have huge budget deficits and hence the policy implication of budget
deficits has become an important issue.

7) Objectives of macroeconomic policies in LDCs

The main macroeconomics objectives of the MDC are full employment, increase output
and price and exchange rate stability. Apart from these LDCs have other issues to address
and objectives to achieve. These include among others:
(A) Exchange rate management: This is because there is an overvalued exchange rate in
most African countries
(B) Stabilization of high inflation: Achieving a targeted low level of inflation per annum
is the main objective of LDCs. Nevertheless, inflation in many African countries is
higher (for example in Zimbabwe it has now become around 2000%) than targeted due
to failure of stabilization policies to yield the desired target. Low level of investment,
slow output growth, high public expenditure and use appropriate budget deficits
financing mechanisms and in ability of managing imported inflation triggered such as
by the rise in oil prices, which rises mainly transportation cost are the main reasons for
high inflation in Africa.
(C) Debt management: Both the stock (what a country borrow) and flow (unsettled &
what are to be paid) of debt to GDP are very high in Africa. Full stock is defined if the
debt flow is greater that revenue generated from foreign trade. If they are equal it is
defined as constant stock. Even if debt is also very high in MDCs they can pay without
affecting the economy. Failure to achieve sustainable economic growth and mitigate
vulnerability to adverse natural calamities such as drought are among the major
reasons
(D) Reducing capital flight: Both the profits and assets of citizens usually transferred
abroad for security and/or other purposes

8) The characteristics of AD and AS curves in LDCs

 AGGREGATE DEMAND:
Before arriving at the AD curve in LDC, we should examine the four components;
aggregate real consumption ( c ), real disposable household income ( yd ), real private
investment (iP ) , and net export ( NX ) of total DD for domestic output.

To examine the nature of AD in LDC we assume hereafter that world price (P*) is fixed
and the effect of a change in P on the IS curve is zero in the standard LDC model. The
AD curve is downward sloped in ( Y , P ) space like the standard MDC AD curve.
However, it is much steeper than MDC AD due to the following two reasons.

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1) The IS curve, which shifts to the left in the standard MDC model when domestic
P level rises because of its effect on net exports, doesn’t shift in the standard LDC model
because exchange rate is fixed in LDC. In fact, the effect on NX shifts IS to the left in
MDC.

Recall that the export function is X = x( P, e) and e = P * / P . From the export function
∂X / ∂P < 0 . Because the increase in domestic price level (inflation) will reduce P * / P
implying the exchange rate has appreciated. This will in turn reduce the X of a country
where the price level has increased, reduce NX or CAB and thus shifts IS and AD to the
left.

2) However, the IS curve is steeper in LDC due to a high marginal propensity to import (
MPM ) and a low interest elasticity of investment DD.

P P

AD AD

Y Y
AD for Developed countries AD for LDCs

 AGGREGATE SUPPLY IN LDCs: The equation is given by

AS = Y S ( P, r , e,W )

Where, Price (P ) and interest rate (r ) are endogenous while exchange rate (e) and
nominal wage (W ) are exogenous variables. Moreover,
∂AS / ∂P > 0, ∂AS / ∂r < 0, ∂AS / ∂e < 0 , and ∂AS / ∂W < 0 . The main difference between
the standard LDC AS curve and that usually pictured for an MDC are the following.

1 The AS curve of LDC is flatter than MDC. The reason for this is that the MDC is
normally close to full employment with less nominal wage rigidity. In LDC however, it
is more frequently found not only unemployed labour but also an underutilized capital
stock. Thus, due to rigidity of nominal wages and excess ideal (unutilized) resources,
output can be increased without increasing employment (the supply of labour and
employment in an economy), which implies DMPL.
2 The second characteristic is that the increase in r affects AS of LDC through its effect
on the cost of working capital, which is scarce due to low saving in LDCs.
3 Changes in the exchange rate ( e ) shifts the AS curve in LDCs for the domestic price of
imported intermediate inputs and raw materials will be affected.

P AS P
AS

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 Y Y
AS for MDCs AS for LDCs

4.3 The Applicability of Conventional Theories to African Economies

Under this section the impact of restrictive fiscal policy and monetary policies on AD and AS
curves as well as the net effect will be covered.

4.3.1) Restrictive fiscal policy ( ↓ G ):

While restrictive monetary policy is likely to increase both unemployment and inflation in
LDCs in the short run, restrictive fiscal policy is likely to become more effective (successful)
in reducing the price level without the costs of a major recession. A decrease in G will shift
the IS curve to the left from IS 0 to IS 1 . This results not only in a small leftward shift of the
AD curve from AD0 to AD 1 but also a larger shift in AS to the right because interest rate has
fallen from r0 to r1 . Finally, the net effect (result) is a decline in the price level (P ) from P0
to P1 and possibly even an increase in output from Y0 to Y1 . In fact, in the standard MDC
model restrictive fiscal policy reduces both price and output. The increase in output in the case
of LDCs is that because the decline in domestic price level will reduce the cost of intermediate
inputs and raw materials (due to appreciation of domestic currency for real exchange rate or
P * / P has decreased). Graphically,

LM 0

r0 E0

r1 E1 IS 0
IS 1

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 Y1 Y0
AS 0
AS 1
P0 E0

P1 E1 AD 0
AD 1

Y0 Y1

Fig 4.1: The impact of concretionary Fiscal Policy in LDC

If the increase in output is small for the LDC, then import demand is affected very little.
This is because the reduction in G, which increases the government surplus will leave the
balance of trade surplus (or deficit) essentially unchanged. The cumulative effect is thus a
reduction in the monetary base (reserves) and as a result of which economic recession
appears (or will worsen) overtime

4.3.2) RESTRICTIVE (CONTRACTIONARY) MONETARY POLICY (↓Ms):

The standard result following of a decrease in M S is to increase interest rate (r ) , which
then reduces investment, output and P.

However, in LDCs reducing the money supply has a larger impact on LM curve (for a
given P level) because of the low interest elasticity of DD. The availability of low interest
rate on loans from commercial bank also reduces retained earnings, shifting the IS curve
down. The reason why the interest rate enters into the AS function in LDCs is that:
A) The interest rate in the formal market when auctioned is not high as in the
informal market
B) Cost of borrowing is very high for cost of collateral is very high

The impact of concretionary monetary policy is thus a relatively small horizontal shift in
the AD curve. And due to the flatness of the AS curve, any shift that does occur is
relatively ineffective in reducing the price level. In LDC, this restrictive monetary policy
also rises the AS curve to the left through the increase in the interest cost on variable
inputs.

The net impact for the MDC is that the price level falls and output declines moderately; for
LDC, output also falls, but the price level may increase. Therefore, in the short run
restrictive monetary policy has few appealing implications for the policy maker.

LM 1

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 LM 0

r1 E1
r0 E0

IS 0
IS 1

Y0 Y1
AS 1
AS 0
P1
P0 AD 0
AD 1

Y0 Y1

Fig 4.2: The impact of restrictive monetary policy in LDCs

REFERENCE BOOKS
1) Branson, William H. (1998), “Macroeconomics: Theory and Policy”, 2nd Ed.,
Universal Book Stall, 5 Ansari Road, New-Delhi-110 002 (India).
2) Dornbusch, R and Fischer, S. (1994), “Macroeconomics”, 2nd Ed.
3) Jones, C. (2000), “Introduction to Economic growth”, 2nd Ed.
4) Mankiw, G. (200), “Macroeconomics”, 3rd Ed.
5) Pentecost, Eric, (2000), “Macroeconomics: An open Economy Approach”, 2nd Ed.,
Macmillan Press LTD, London
6) Pilbeam, K. (1998), “International Finance”, 2nd Ed.

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Quiz number 1:
1) Using the Cobb-Douglas production function y = aK β L1−β ,
A) drive and show that the
equilibrium capital stock rises with an increase in y and falls with an
increase in real user cost of capital in the flexible accelerator investment
model
B) Drive also the gross
investment assuming that the real user cost of capital remains fairly
constant overtime, ceteris paribus.
2) Assume that the valves of y , C , and P in an
economy are 10, 4, and 1respectivelly. Further, assume that β is 80% and net
saving ratio (s ) is 40% in 2009. Further assume that the real user cost of capital

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remains fairly constant overtime, ceteris paribus. Given these information, calculate
the value of
A) real user cost of capital
B) net investment (the change in
equilibrium capital stock) if output ( y ) increases to 12 in 2010
C) growth rate of output in the
economy in 2010 that would maintain supply equal to demand
D) output change
E) gross investment, if the
depreciation rate of capital stock in the economy ( δ ) is 10% in 2010

93