MODULE INTRODUCTION

Macroeconomics deals with economic analysis at aggregate level. It deals with national income
like Gross Domestic Product (GDP), Unemployment, Inflation, etc. This Macroeconomics
course has seven chapters presented in two modules. In the first module we presented four
chapters. In the first module is an introductory macroeconomics, the second module aims at
covering some advanced macroeconomics. The first module of the course is divided in such a
way that it covers four units.

The module starts with Unit-1, which covers introduction part of the course; Unit-2 covers the
national income accounting; Unit-3 focuses economic performance and business cycle; and Unit-
4 covers consumption spending.

All units of are divided into smaller sections followed by activities and exercises. At the end of
all units self-assessment tests are given to know the progress of the students followed by unit
summary. The answers to the self-tests are given at the end of the module. A list of suggested
reading material is given at the end of each unit and a general reference list is given at the end of
the module. In order to prepare the module has given a model question paper.

MODULE OBJECTIVES

Module of Macroeconomics is prepared in a simple and flexible way such that it can help the
students to have general macroeconomics concepts and apply in real world. The objectives of
this module are to:

 introduce the students to various macroeconomics variables and its role in

shaping macro economy;

 explain the national income accounting, economic performance and business

cycle, consumption spending in the economy.

 explain investment, money market and labour market and their role in economy.

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MODULE I

In this module I you will be exposed to introductory level of macroeconomic concepts where we
shall be dealing with the unit one to unit four of the course. These four units cover: Introduction;
National Income Accounting; Economic Performance and Business Cycle; and Consumption
Spending.

The module is designed in such a way that students are given chances of checking their progress
through self-assessment tests and exercises following different sections of discussion and units.

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 TABLE OF CONTENTS

MODULE INTRODUCTION i
MODULE OBJECTIVES i
MODULE I ii
TABLE OF CONTENTS iii
UNIT ONE: INTRODUCTION 1
1.1 Introduction............................................................................................................................1
1.2 Learning objectives:...............................................................................................................1
1.3 Key Concepts for Review......................................................................................................1
1.4 Definition of Economics........................................................................................................2
1.5 Branches of Economics.........................................................................................................3
1.6 Elements of National Economy.............................................................................................6
1.7 State of Macroeconomics: Evolution and Recent Developments..........................................7
Self-test 1...................................................................................................................................10
Unit Summary............................................................................................................................11
Suggested References................................................................................................................13
UNIT TWO: NATIONAL INCOME ACCOUNTING.................................................................14
2.1 Introduction.....................................................................................................................14
2.2 Learning objectives:........................................................................................................14
2.3 Key Concepts for Review...............................................................................................15
2.4 A General overview of the Major Macroeconomic Models...........................................15
2.4.1 Two sector model....................................................................................................16
2.4.2 Three sector model (closed economy model)..........................................................17
2.4.3 Four sector model (Open Economy model).............................................................18
2.5 National Income Accounting..........................................................................................20
2.5.1 Real GDP versus Nominal GDP..............................................................................21
2.5.2 Gross domestic product (GDP) and Gross national product (GNP)........................25
2.5.3 Precautions to be made in measuring GNP and/or GDP.........................................26
2.5.4 Other National Accounts Measures.........................................................................26
Exercise 2.1................................................................................................................................29
2.6 Approaches to ‘National Income Accounting’ process..................................................30
2.6.1 Value added approach..............................................................................................31
2.6.2 Expenditure Approach.............................................................................................32

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 2.6.3 Income Approach.....................................................................................................34
Exercise 2.2................................................................................................................................37
2.6.4 The Drawbacks/Shortcomings of GDP and/or GNP...............................................39
Unit Summary............................................................................................................................40
Self-Test 2..................................................................................................................................43
Suggested References................................................................................................................45
UNIT THREE: ECONOMIC PERFORMANCE AND BUSINESS CYCLE..............................46
3.1 Introduction..........................................................................................................................46
3.2 Learning Objectives:............................................................................................................46
3.3 Key Concepts for Review....................................................................................................47
3.4 The concept of the business cycle.......................................................................................47
3.4.1 Definition and Concepts of the Business Cycle...........................................................48
3.4.2. Phases of the Business Cycle.......................................................................................48
3.4.3. Business Cycle and Output Gap..................................................................................51
3.5 Theories of the Business Cycle and Indicator Forecasting..................................................53
3.5.1. Theories of the Business Cycle........................................................................................53
3.5.2. Forecasting Business Cycle: Indicator Forecasting.........................................................57
Self-test 3...................................................................................................................................59
Unit Summary............................................................................................................................61
Suggested References................................................................................................................62
UNIT FOUR: CONSUMPTION SPENDING 63
4.1 Introduction..........................................................................................................................63
4.2 Learning Objectives:............................................................................................................63
4.3 Key Terms for Review.........................................................................................................64
4.4 Consumption Spending and Aggregate Demand.................................................................65
4.4.1 Consumption and Aggregate Demand: Their Relationship..........................................65
4.1.2. The Consumption Function.........................................................................................66
4.1.3. Properties of Consumption Function...........................................................................67
4.1.4. Derivation of the saving function................................................................................72
4.1.5. Keynesian Consumption Puzzle..................................................................................75
Exercise 3.1................................................................................................................................78
4.5 Theories of Consumption....................................................................................................80
4.5.1 Keynesian Absolute Income Hypothesis......................................................................81
4.5.2 Relative Income Hypothesis:........................................................................................82
4.5.3 Fisher’s Intertemporal Model of Consumption............................................................84

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 4.5.4 Modigliani Life Cycle Hypothesis (Ando - Modigliani Approach).............................88
4.5.5 Permanent Income Hypothesis (Friedman Approach).................................................91
Exercise: 3.2..............................................................................................................................95
Self-Test Exercises -3................................................................................................................97
Unit Summary..........................................................................................................................101
Suggested References..............................................................................................................102
Answer for self-tests................................................................................................................102

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UNIT ONE: INTRODUCTION

1.1 Introduction

This course is meant to introduce you with the basic macroeconomic concepts and theories that
will help you understand how an overall economy works. But, before we rush in to details of the
macroeconomic concepts and theories, we shall see some introductory issues. Accordingly, this
chapter is devoted to the discussion of the meaning of the broad subject economics and
macroeconomics as a branch of economics. Specifically, this chapter will present you the
different definitions of economics, classification of economics, the major elements of analysis in
macroeconomics and the historical evolution of macroeconomics as one field of study.

1.2 Learning objectives:

At the end of this chapter you are expected to be able to:

 Define the subject economics;

 List the different branches of economics;
 Distinguish between the different branches of economics;
 Define macroeconomics;
 Explain the different elements of macroeconomics and
 Explain the historical evolution of macroeconomics.

1.3 Key Concepts for Review

 Scarcity  Elements of macroeconomics

 Choice  Interventionists
 Macroeconomics  Non-interventionists
 Microeconomics  Invisible hand
 Normative economics  Price rigidity
 Positive economics

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1.4 Definition of Economics

Dear learner the nature and scope of the science of economics have dramatically grown through
time. And as economics has become very wide and vast subject, so were the definitions given to
it. Different economists define the subject from different angles like scarcity, unlimited wants,
choices etc. However, the central point of these definitions is one and the same that
economics is the study of how individual agents and/or society as a whole may secure the
best out of the available resources. Though they are given from different angles, the different
definitions of economics build one on another that it will be important to see some of them to get
a complete understanding of the subject.

 According to one of the most popular definitions, economics is a social study of

production, distribution, and consumption of wealth or output. This definition
emphasizes three major economic activities. According to the definition first output must
be produced (production); second, the product must be distributed to potential consumers
(distribution); and finally, consumers must choose from the available goods for
consumption (consumption). Economics is concerned with the study of how best these
three economic activities may be planned and done to achieve maximum wellbeing for
individual economic agents and/or society as a whole.

Others define economics as the study of choice. Economic agents (producers and consumers)
make choice because of scarcity. Scarcity puts constraints or limitations of resources on the
production or consumption activities of economic agents. In other words, human wants being
unlimited, the fact that the means to satisfy them (resources) are of scarce supply implies that
economic agents must prioritize their wants and pick the most valuable ones which we formally
call a choice. Hence, economics is a study of how economic agent can make proper choices so
they can maximize their satisfaction from the scarce resources available.

Similarly, Economics is also defined as the study of decision making. The science of economics
is used to make the appropriate decisions regarding the basic economic questions. That is, with
the help of economic principles; people may easily decide on:

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 a) What to produce: The answer to this question may help determine which
product is profitable for producers in terms of revenue or profit.

b) How to produce: the answer to this question may help determine what
production method or technique to use and about what inputs to use.

c) For whom to produce: This question helps us identify our potential customers,
for example, whether farmers or students. The answer to this question may help us the
answer to the next question.

d) Where to produce: Understanding this question is the view that the location of
our production unit or distribution center depends on the location of our potential
customers.

e) When to produce: The answer to this question helps us determine the season of
high demand for your product.

Still for others, economics can be defined as the study of wise and efficient use of the limited
resources. It is a science which tries to reconcile unlimited human wants and limited economic
resources to meet this wants. It is a science which tries to find out the method of optimal or
proper use of scarce economic resources. It tries to identify the way that helps economic agents
(human beings) produce maximum output or benefit from limited resources i.e. money, natural
resources, human resources, etc.

1.5. Branches of Economics / scopes of economics

Dear learner, economists have classified economics into different branches based on different
perspectives. Let us see them one by one.

I) One way of classifying economics is based on the point of view or elements of economic
analysis. In this classification, economics has two major branches:

a) Microeconomics and

b) Macroeconomics.

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Microeconomics studies the markets for single commodities, examining the behaviour of
individual households and businesses. It focuses on how competitive markets allocate
resources to create producer and consumer surplus, as well as on how markets can go wrong.
These two groups of economists differ in their view of how markets work. Micro economists
assume that imbalances between demand and supply are resolved by changes in prices.
Rises in prices bring forth additional supply, and falls in prices bring forth additional demand,
until supply and demand are once again in balance.

Macroeconomists examine the economy as a whole focusing on feedback from one

component of the economy to another, and studying the total production and employment
level. Macroeconomists consider the possibility that imbalances between supply and demand
can be resolved by changes in quantities rather than in prices. That is, businesses may be
slow to change the prices they charge, preferring instead to expand or contract production until
supply balances demand.

II) From the view point of interest whether to deal with economic
explanations /understandings/ or with what should be done to change or improve the
existing economic conditions (whether to deal with value judgment or not), we can also
divide economics into two major branches:
a) Positive economics and
b) Normative economics.

Positive economics is a branch of economics which is concerned with the explanations of

existing economic conditions. It tries to answer the question “What is?” such as “What is the
price of commodity X in market A?” The answer may be 10 Birr or 100 Birr per unit. This shows
that positive economics tries to understand the existing economic situation.

Normative Economics, on the other hand, deals with value judgment on economic situation. It
tries to answer the questions “What should be?” such as “What should be done to increase
employment?” The answer may be cutting wage rates or increasing the government expenditure
on the construction of public infrastructure so that the unemployed will be employed in the
project and that they in turn generate employment through spending their increased income.

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 C) Economics can also be classified based on the type economy in which economic
principles are used to solve economic problems. One way of dividing the world
economy is on the basis of the economic policies a country follows. From this
perspective, we can divide the world economy into three: Command economy, Mixed
economy and Market economy.

a) Command economy is the type economy where economic variables (prices, output etc.)
are controlled by the government. For instance, during Dergue regime, Ethiopia was in a
command economy as several economic sectors were controlled by the government
during that period.

b) Mixed economy is the case the government control on the economy is less and market
plays significant role in determining the level of economic variables such as output level
and price. Not all economic variables are under complete control of the government in
this type of economy.

c) Market economy is the type of economy where values of economic factors are
determined by market forces. The government role in this type of economy is limited to
provision of basic public services like defence and the control over markets is fairly zero.
Such economy is characterized by high competitions among firms. Most of the
economies of the developed countries more or less follow this type of economy.

We hope that you are getting the ideas discussed above. Let us quickly complete the following
activity in order to understand better and prepare for the next topics.

Activity 1.1

a) What do you think economics is about before you read the previous part? Please share
your views with your partner and compare them with definitions provided.

b) Can you make a couple of normative and positive statements about the economy of
Ethiopia? Please share with your partner.

c) To which type of economy do you categorize the current economic system of

Ethiopia? Please discuss with your partner.
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 d) Can you enumerate at least three indicators of the performance of an economy?
Please share with your partner.

e) Do you think the government of Ethiopia should intervene to regulate markets or

leave market free? Which one do you think is best for society? Please justify your
answer and share it with your partner.

1.6. Elements of National Economy

Macroeconomics deals with the behaviour of the economy as a whole. It is generally concerned
about issues like the performance and/or fluctuations in the overall economy and the
circumstances they are attributed for. Such macroeconomic issues are analyzed by examining the
trend of certain elements of the macro economy. Put differently, national economic behaviour
(the behaviour of an economy as whole) and some of the most important concepts that
macroeconomics deals with are mostly described by using the elements of the macroeconomy.
Dear learner, most of these macroeconomic elements will be discussed in detail in the
forthcoming chapters. But, we shall introduce some of them in this section with brief description
presented below.

a) Gross Domestic Product (GDP) is the sum of values of total goods and services produced in
a given country in a given period of time (a year). This can be obtained by aggregating the
values of goods and services produced in different sectors of the economy.
b) Government expenditure is the amount of resources that the government sector of a country
spends in a given fiscal year (budget year). This expenditure includes both consumption
expenditure and investment expenditure in such activities as construction of roads, schools,
clinics and hospitals, water supply, electrification and others.
c) Total money supply is the amount or size of total currencies in circulating in the economy
which is controlled to the appropriate level by Central Bank.
d) Inflation represents a rise in general price level. During inflation prices of all goods and
services become high. As a result of this the purchasing power of money (or value of Currency)
decreases. For instance, 100 Birr cannot purchase what it used to purchase before inflation.
There are several factors that lead to inflation such as excess money supply or less production.

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e) Trade Balance is the net inflow of foreign exchange from trade (export and import). It is
the value of net export of a country. It is measured by the difference between export from and
import into a country; i. e. total export value (X) minus total import value (M). A positive value
of this term shows surplus balance of trade indicating good performance of that country.
f) Balance of Payment (Bop) is the net of inflow of resources to a given country/economy from
the rest of the world. This includes the flow of all resources. It does not refer to flow of
resources only from trade services. In addition to the current account balance, the balance of
payment (Bop) includes the flow of resources from foreign investment, borrowings from the
rest of the world (short term, medium term, and long term), and repayments of such borrowings.
g) Exchange rate refers to the rate at which domestic currency is exchanged for foreign
currency.
h) Consumer price Index (CPI) is the measure of weighted average of prices of goods and
services used by consumers. It is the measure of cost of living. Like GDP which measures or
converts all goods and services in a given economy/country to a single figure, CPI measures
prices of several goods and services into a single price.
i) Per capita Income (PCI) is the measure of average output of a country per person which is
one of the best measures of the wellbeing (or the welfare) of citizens of the country. It is the
ratio of the total output Gross Domestic Product (GDP) to total population (N) of the country.

PCI =

1.7. State of Macroeconomics: Evolution and Recent Developments

Dear learner, macroeconomic thoughts have evolved considerably over time. Contemporary
macroeconomic ideas have evolved over time beginning from the mercantilist (1500s – 1600s)
period to present. The focuses of most of these ideas are on the way national development or
better economic performance can be achieved. According to Mercantilists, national development
(wealth of nation) can be achieved by accumulating precious metals, especially gold through
international trade which they thought to be a zero sum game.

Later, the thinking of national economic development changed to the need or type of government
actions that should or should not be undertaken in the economy. This is related to whether the

7
government can or cannot intervene in the economy to improve its performance/well-being.
Different ideas have developed over time on response to this question. The Classical and
Keynesians are the dominant thoughts behind the development of these ideas. The other major
schools of economic thought share some points both with Keynesians or Classical economists. In
general term these schools can be categorized either as interventionist (similar position with
Keynesians) and non-interventionist (similar position with classical economists).
Interventionist believes that government intervention is necessary for efficient functioning of the
nation. Whereas non-interventionist believe that market are basically efficient and hence there
should not be any government intervention in the economy.

The major schools of thoughts include classical, neo-classical, new classical, monetarist,
Keynesian and new Keynesian and each of them remained influential in different periods.

Among these, the classical economists which include Adam Smith (1723-1790), David Hume
(1711-1776), David Ricardo (1772-1823), John Stuart Mill (1806-1873), Knut Wicksell (1851-
1926), and Irving Fisher (1867-1947); are popular for their noninterventionist opinion. They
asserted that there must not be government intervention in the market, because the market
operates at full employment and any deviation from the market is adjusted through invisible hand
(Adam smith). According to them, both fiscal policy and monetary policy are useless that they
do not affect the real economic variables such as GDP. The former just raise interest rate and
crowds out investment while the latter just raises prices and does nothing to “real” things.
Therefore, for the classical economists, there is no need for intervention by the government
intervention and we shall just leave all the assignment for the markets. This is what usually
called “Laissez-faire” economics.

The Keynesians, led by John Maynard Keynes, support the intervention of the government in
the economy, unlike the classical economists. Especially after the occurrence of great depression
of the 1936, the Keynesians widely advocated the adoption of fiscal policy as the classical
“invisible hand” proved to fail practically. For the Keynesians, markets do not adjust
automatically like the classicals asserted because of price rigidities. Thus, it is quite likely that
markets fail to clear which means that expenditures (aggregate demand) may lag behind output
(aggregate supply) and the economy may remain below full employment levels resulting in

8
economic stagnation. Hence, this situation calls for intervention of the government using fiscal
policy.

Similarly, proponents of Monetarism (led by Milton Freidman), advocated the intervention of

the government but by manipulating money supply and interest rate (using monetary policy)
on the contrary of Keynesian economists.

On the other hand, proponents of the neo-classical school like Alfred Marshal were opponents
of government intervention like the classical school. But, though both of them advocate the non-
intervention policy, they had certain difference in their thinking’s. The basic difference between
them is that the classical economists follow an objective method and emphasize on wealth while
the neo-classicals are humanists (also called subjectivists) and emphasize on human welfare.

Self-Assessment Test: 1.1

Dear learner, please put a tick mark (√) or (x) in front of the activities to confirm whether
you can or cannot perform/understand the listed activities. I can:

1) Define economics and macroeconomics ---------------------------------------------------□

2) List out the branches of economics ---------------------------------------------------------□

3) Distinguish between macroeconomics and microeconomics ----------------------------□

4) Distinguish between positive and normative economics ---------------------------------□

5) Distinguish between command, mixed and market economic systems ---------------□

6) List at least five of the major elements of macroeconomics -----------------------------□

7) List at least three of the schools of economic thought-------------------------------------□

8) compare the views of the interventionists and the non-interventionists --------------□

! If more than one of your responses to the above questions is ‘Negative or not ticked”,
please go back and re-read the above lesson and discuss with partner.

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Have you completed the above part? Now it is time to complete the following self-test exercise.
If you face any difficulties, please read the section again.

Self-test 1

1. Macroeconomics is the study of ___________________

A. An individual building blocks in the economy
B. The relationship between individuals in the economy
C. Household purchase decisions
D. The economy as a whole
E. All of the above
F. None of the above

2. The economy of Ethiopia is scoring a double digit growth for the last decade. This statement
is best described as:

A. A positive statement

B. A normative statement

C. Both positive and normative statement

D. Neither positive nor normative statement

3. The type of economy in which the governments intervention is limited to provision of basic
public services and economic variables are solely determined by markets is:

A. Command economy

B. Mixed economy

C. Market economy

D. None of the above

4. Which of the following schools of economics is interventionist?

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 A. Classical economics

B. Keynesian economics

C. Neo-classical economics

D. Monetarists

E. All of the above

F. None of the above

5. Which of the following wrong for classical economists?

A. Any disequilibrium in the market is adjusted with the invisible hand.

B. Increased government expenditure crowds out private investment.

C. Expansionary monetary policy increases prices and nominal income.

D. Expansionary monetary policy increases stimulates economic growth.

E. All of the above.

F. None of the above.

Unit Summary

We started this unit by presenting the different definition of economics. Economists provide a
wide range of definitions of the subject one building on the other but from different angles like
scarcity, unlimited wants, choices etc. In summary, economics may be defined as the study of
how individual agents and society as a whole may secure the best out of the available resources.

We have also seen how economists classified economics into different branches based on
different perspectives. The most popular classification is based on the point of view or elements
of economic analysis. In this classification, economics has two major branches: Microeconomics
and Macroeconomics. The former is concerned about the markets for single commodity and the
behaviour of individual households and businesses while the latter is concerned with the

11
behaviour of the economy as a whole. Alternatively, we can divide economics as positive
economics and normative economics. Positive economics is concerned with the explanations of
existing economic conditions while normative Economics deals with value judgment on
economic situation. Economics can also be classified based on the type economy in which
economic principles are used as the economics of Command, Mixed and Market economy.
Among the branches of economics, macroeconomics is going to be discussed throughout all
chapters of this course. It is generally concerned about issues like the performance and/or
fluctuations in the overall economy and the circumstances they are attributed for. Such
macroeconomic issues are analyzed by examining the trend of certain elements of the
macroeconomy. These include the GDP, government expenditure, BOP, inflation, trade balance,
exchange rate, money supply etc.

The contemporary macroeconomic, which we are about to start detailed discussion it in this
course, thoughts have evolved considerably over time beginning from the mercantilist period to
present. The focuses of most of these ideas are on the way national development or better
economic performance can be achieved. According to Mercantilists, national development can
be achieved by accumulating precious metals through international trade.

The issue of economic thinking gradually changed to the role of government actions in the
economy. This is related to whether the government can or cannot intervene in the economy to
improve its performance/well-being. Different ideas have developed over time on response to
this question. The Classical and Keynesians are the dominant thoughts behind the development
of these ideas leading the other schools of thought. In general term these schools can be
categorized either as interventionist (Keynesians) and non-interventionist (classical economists).
Interventionist believes that government intervention is necessary for efficient functioning of the
nation. Whereas non-interventionist believe that market are basically efficient and there should
not be any government intervention in the economy.

Suggested References

Branson W. (1989), Macroeconomic Theory and Practice, Third edition, New York Harper and
Row Publishers

12
Edward Shapiro; Microeconomic Analysis (2000), 5th Edition, Harcourt Brace Jovanovich, Inc,
New York.

Gardner Ackley; Macroeconomics. Theory and Policy, 1987, McMillan.

Gregory Mankiw; (2000), Macroeconomics. Worth publishing.

R. Dornbusch and S. Fisher; Macroeconomics (1994) 2nd Edition, or any other edition, New
York, McGraw-Hill International Edition.

13
UNIT TWO: NATIONAL INCOME ACCOUNTING

1.1 Introduction

In this unit, our attention will be on national income and its accounting process. Since
macroeconomics deals with the whole country, it is important to know the income of the
economy, and its sources. We will also discuss about methods of measuring the value of total
output of a country called ‘national Income accounting’ process and related concepts.

National Income Accounting process refers to the process of record keeping for the overall
economic activities of a given country. It includes the goods and services produced in a country
in a year. It is the process of measuring national output, Gross Domestic Product (GDP) or Gross
National Product (GNP). It also deals with national economics values such as net domestic
product, net factor payment, disposable income and other macroeconomic values.

1.2 Learning objectives:

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

 List the major macroeconomic models;

 Show circular flow of income and expenditure corresponding to major macroeconomic

models;

 Define National Income Accounting;

 Identify and explain the major elements of National Income Accounting process;

 Calculate the national output, GDP or GNP, Net Domestic Product, Net Factor Payment,
disposable income and other macroeconomic values;

 Make distinctions among the major approaches to National Income Accounting process;
and

 Distinguish between:

o Real GDP and Nominal GDP

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 o Gross Domestic Product (GDP) and Gross National Product(GNP)

1.3 Key Concepts for Review

 National Income Accounting  Net Domestic Product (NDP)

 Gross Domestic Production (GDP)  Income Approach
 Gross national Product (GNP)  Expenditure Approach
 Nominal GDP  Value Added Approach
 Real GDP  Employees compensations
 Net Factor Payment (NFP)  Dividends
 Disposable Income (Yd)  Depreciation

1.4 A General overview of the Major Macroeconomic Models

Depending on the tools of analysis and macroeconomic elements to be considered, several

macroeconomic models have been developed and used as tools of analysis of cause effect
relationship among macroeconomic variables and for macroeconomic policy formulation in
different sectors of a given economy. Some of these models are used for computation
(calculation) or estimation of some other macroeconomic values. Some of these models are:

- Investment and saving models

- Growth models
- Consumption models
- Aggregate demand and supply models
- IS-LM model
- Fiscal and monetary policy models (multiplier model)
- Current account model
- Mundell-Fleming model and so on.

 From the point of view of the number of sectors involved in the analysis or in the model,
there are three major macroeconomic models:

a) Two sector model

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 b) Three sector model (Closed Economy model)

c) Four sector model (Open Economy model)

1.4.1 Two sector model

This model represents the case where there are only two sectors in the economy. The two sectors
are household sector and the firm sector. This model is represented by the relation or use of
income by households i.e. consumers or households either consume or save their income. This
relation is given by the following equation:

Where Y = income, C = Consumption expenditure and S = Saving

Since saving is used for investment or saving is by itself a form of investment, S = I, the above
equation can be rewritten as:

Where I = investment spending

This model can be demonstrated using circular flow of income and expenditure as follows (see
Figure 2.1). Households sector is the owner of factors of production like land, labour and capital.
These factors of payments are exchanged in resource market. In other words, factors of
production are used by the firms and in return firms pay in terms of wages, interests and rent.
These payments to the factors of production are nothing but the income (Y) from firms in the
form of wage for their labour or in the form of rent on their land or interest in the form of capital.
These factors of production spend part of their income on consumption goods (C) produced by
firms and save the rest given by (S). For the sake of simplicity, let us assume that all the income
received by the households is consumed. We will introduce savings later.

Figure 2.1: Circular flow of income and spending in two-sector model

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 Resource Wages, Interest,
Income Market And Rent
birr
Factors of Production

Households Firms

Goods and
Services

Product Revenue birr

Consumption Market
Birr

Business sectors produce the outputs to be sold in product market. These outputs are consumed
by the households by spending their income. Business sector receives revenue form the
consumption. In this two sector model we have not introduce the role of savings and investments
which will be introduced in three sector model.

1.4.2 Three sector model (closed economy model)

This model incorporates government sector. Therefore, household, firms or the business sector
and government are the three parties involved in the economy. This model is also known as
closed economy model because it does not include or consider trade with other countries. This
model is represented by the following equation:

Where G = Government spending/ expenditure

In addition to activities mentioned in two sector models above, households receive income from
government transfer payments and pay tax to the government. In similar ways, business firms

17
 also sell their goods and services to the government and pay tax to the government. Government
sector on their part use the tax income to finance its expenditure.

Figure 2.2: Circular flow of income and spending in three sector model

Households Income (Y) Firms

Saving (S)
Investment (I)
Consumption (C)

Taxes Government Taxes

(G)

Transfer payments Government spending

1.4.3 Four sector model (Open Economy model)

In addition to the three sector model, this model includes trade with other countries. As a result,
the elements of trade such as import and export are incorporated in the model. This model is
represented by the following equation:

Where:

C= Consumption expenditure;

I= Investment expenditure;

G= Government expenditure;

NX = Net export (X – M);

M = Import value; and

18
 X = export value

The four sector (open economy) model can also be demonstrated by the use of circular flow of
income and expenditure as follows (see Figure 2.3).

By the introduction of foreign sector, the household sector and business sector can benefit by the
imports and exports. Households can get imported products at the same time, business sector can
also exports to other countries. Households spend on imported commodities by paying foreign
exchange and business firms receive foreign exchange income by exporting their products. In
this model the government plays a crucial role in regulating the foreign exchange market along
with its previous role of collecting taxes and government spending.

Since almost all countries around the world have government involvement in the economy and
have foreign trade with other countries, the third model is a more realistic one. Therefore, in this
chapter, we discuss the national income accounting based on the four sector model or open
economy model.

19
Figure 2.3: Circular flow of income and spending in four sector model

Households Income (Y) Firms

Saving
(S) Investment (I)

Consumption (C)

Taxes Taxes
Government
(G)

Transfer payments Government spending

Imports (M) Foreign trade Exports (X)

1.5 National Income Accounting

‘National Income Accounting’ is the process of finding out the net output of a country through
additions of value added and payments received after deductions of depreciations and payments
to foreign economy. National Income Accounting is about measuring the value of economic
activity such as Gross Domestic Product (GDP) and /or Gross National Product (GNP).

The single most important measure of overall economic performance is gross domestic product
(GDP). Measuring GDP is an attempt to summarize all economic activity over a period of time
in terms of a single figure/number; it is a measure of the economy’s total output and total
income. In other words, GDP is the value of all final goods and services produced in the
economy in a given period of time (normally the period of time is one year).

20
 1.5.1 Real GDP versus Nominal GDP

Nominal GDP is the value of all final goods based on the prices existing during the time period
of production. In other words, it is the price we pay in the market. Nominal GDP can grow in
three ways

 When output rises and prices remains constant.

 Prices rises and output remains unchanged.

 When both prices and output rises

The problem, then, is how to adjust GDP so that it reflects only changes in output and not
changes in prices. This adjustment helps us in comparing the GDP over time when prices are
changing. In order to know this we must understand the meaning of real GDP. Real GDP is the
value of all final goods produced during a given time period based on the prices existing in a
selected base year. Ethiopia uses 1980/81 prices as the base year. The value of national output
obtain ed by the use of such base year price is known as Real Gross Domestic Product (RGDP).
Real GDP is also known as GDP in constant price or Birr. It is GDP adjusted for inflation. The
adjustment factor is known as GDP deflator. The GDP deflator and consumer price index are
indexes measure of change in the general price level. GDP deflator is the ratio of nominal GDP
to real GDP.

GDP deflator can also be calculated from the outputs and services produced and their respective
base year as well as from the current prices as follows.

Where;

21
QCi = current unit of output or service or item ‘i’. (i = 1, 2, 3, ………)

PCi = current price of output or service or item ‘i’ (i = 1, 2, 3, ………)

PBi = base year price of output or service or item ‘i’(i = 1, 2, 3, ………)

Consumer price index is calculated in the same manner as is the GDP deflator. That is the
‘Consumer Price Index (CPI) is calculated by the relation

The difference between the two are that GDP deflator measures the prices of all goods and
services (including expenditure of both firms and households) whereas CPI measures the prices
of all goods and services purchased by consumers. The other difference between the two
measures is that GDP deflator includes only outputs produced domestically whereas the CPI
includes price of imported consumer goods as well.

Illustrating Example

Given the following data/information on total output (goods and services) and price level
(average price) in respective years we can calculate nominal GDP, rear GDP and GDP deflator.

Note that in this particular exercise we assume that all goods and services are measurable in
similar units for sake simplicity. Let us take year 1970 as the base year and assume the base year
is changed to the year 1990. So the real GDP is calculated using price of the year 1970 up to
1988 we will use the 1990 price in calculating the real GDP, because year 1990 is selected as
base year for the periods to come after this year. Thus, the following Table 2.1 gives the result.

From the Table 2.1 we can understand that in the year selected as base year both nominal GDP
and real GDP are equal. This is because both values are calculated using the same price. That
means, since the year, which is selected as the base year, is also the current year, the base year
the current year price will be the same.

From this example, we can also see that nominal GDP may change simply because of change in
price level even if there is no change in physical output. However, real GDP remains
22
unchanged if there is no change in physical output. For instance, compare both values of real
GDP and nominal GDP of the years 1980 and 185. Since there was no change in physical output
(15 units in both years) there is no change in real GDP too, which remains 30 million Birr in both
years.

We can see the same case in years 1994 and 1996 where here is no change in real GDP whereas
the nominal GDP has increased simply because of an increase in price level (i.e. from 10 to 11
Birr per unit) even if there is no change in physical output which remains at 30 million Birr in
both years.

Table 2.1: Real GDP and Nominal GDP

Unit of goods and Nominal GDP Real GDP

services (in Price (NGDP) (in million (RGDP) (in GDP deflator
Year million) level Birr) million Birr) (NGDP/RGDP)

1970 10 2 20 20 1

1975 12 3 36 24 1.5

1980 15 4 60 30 2

1985 15 6 90 30 3

1988 20 7 140 40 3.5

1990 25 8 200 200 1

1994 30 10 300 240 1.25

23
1996 30 11 330 240 1.375

1998 32 15 480 256 1.875

1999 34 18 612 272 2.25

2000 35 20 700 280 2.5

Self-Assessment Test 2.1

Please put a tick mark (√) or (X) in front of the activities to confirm whether you can or cannot
perform/understand the listed activities.

1) Define nominal GDP, real GDP and GDP deflator----------------------------------------------□

2) Explain the difference between real GDP and nominal GDP---------------------------------□
3) Calculate really GDP and nominal GDP----------------------------------------------------------□
4) Calculate GDP deflator from nominal GDP and real GDP-------------------------------------□
5) Differentiate between GDP deflator and Consumer Price Index -----------------------------□
! If more than one of your responses above questions are “not ticked’’, please go back
and re-read the above lessons.

24
 1.5.2 Gross domestic product (GDP) and Gross national product (GNP)

Gross domestic product (GDP) is the sum of values of goods and services produced in the
country by citizens of the country and foreigners. Therefore, GDP is something related to
territory of the country (i.e. GDP is territorial) whereas GNP is something related to citizenship
(i.e. GNP is national). The difference between GNP and GDP equals to the net income earned
by foreigners (NFP).

The relation between the two values GDP and GNP is given as:

GNP – GDP = NFP implying

Here NFP is net factor payment to the citizens which is the difference between income received
by citizens of the country outside the country and income received by foreigners in the country.
When GDP exceeds GNP, residents of a given country are earning less abroad than foreigners
are earning in that country.

Example:

Suppose Ethiopians abroad have produced output worth of 200 million Birr in the year 2014 and
at that time, foreigners working in Ethiopia have produced output worth of 150 million Birr in
the same year. If the Ethiopian GDP in that year is, 800 million Birr, assuming that other things
remaining constant, the net factor payment (NFP) and the GNP are given as follows:

NFP = GNP – GDP

NFP = 200 – 150

NFP = 50 million Birr

GNP = GDP + NFP

GNP = 800 + 50

GNP = 850 million Birr

25
 1.5.3 Precautions to be made in measuring GNP and/or GDP

1. Money must be used as common unit of measurements.

2. Market values of goods and services should be applied.

3. Only final goods and services should be considered or included in the calculation of GDP.
That is, we need to avoid measuring intermediate inputs. This helps to avoid double
counting. There is one income accounting approach which measures intermediate inputs as
well. But this method is subject to the risk of double counting (repeating or adding the same
value more than once in the same GDP value).

4. Non-productive transactions should not be included in GDP. For instance: Sales of second-
hand goods and financial transaction.

5. Products in informal sectors should be included in GDP

1.5.4 Other National Accounts Measures

Net National product (NNP) or Net Domestic Product (NDP): these values are usually used
interchangeably because there is no significant difference between the two values. The only
difference between the two is that Net Domestic Product (NDP) is calculated from Gross
Domestic Product (GDP) whereas Net National Product (NNP) is calculated from Gross National
Product (GNP). The difference between GDP and GNP is equal to or the same as the difference
between NDP and NNP. It can be calculated as

NDP = GDP – (Depreciation)

National income (NI or Y): is the difference between Net National Product (NNP) or Net
Domestic Product (NDP) and Indirect Taxes (IT). These taxes are deducted from Net National
Product (NNP) or Net Domestic Product (NDP) before making factor payments.

NI or Y = NNP – IT or

26
Where: IT represents indirect taxes.

For instance, if total output of the country (GDP) in a given year is 100 million USD and the lost
part of capital is goods in generating this national output is 9.5 million US dollar, then the net
domestic product (NDP) of the country in that particular year is given as follows:

NDP = GDP – D

= 100 million – 9.5 million USD

= 90.5 million USD

Personal income (PI): The value of personal income (PI) is the net value of national income and
different personal payments and receipts. It is given by the following relation.

Where:

 Social security payments are the amount collected from individuals to help the poor, the
disabled and the senior citizens of the country.
 A corporate income tax is taxes collected from profit or revenue of corporate
organizations (from organizations not from individuals) by the government.
 Retained earnings are part of income generated by corporate organizations and kept in the
organizations for generation of more profit or for strengthening the capacity of the
organization or company. This part of organizations’ revenue or profit is not disbursed/
paid out to members of personal uses.
 Transfer payments are amounts of money people receive from their relatives or friends
for free.

27
  Subsidies are amount of money or equivalent amount of other goods and services given
by the government to individuals, companies or organizations to help them.
 Interest income is amount of income received on the saved amount of money in the
banks.

Disposable income (Yd): is the amount of income that is left for a person after payment of any
taxes and transfers. It is the amount that the person is free to spend on whatever he/she likes or to
save. It is given by the following identity.

However, sometimes all transfers and taxes are considered at the same time. In that case, the
disposable income is directly calculated from national income which is usually represented by
(Y). Thus, the disposable income identity is given as follows.

Disposable income (Yd) = National Income(Y) + Transfers – Taxes

Personal savings (S): Personal saving is the amount of disposable income that is left over and
above consumption expenditure. In other words, personal saving is the difference between
disposable income (Yd) and consumption expenditure (C) and it is given as follows:

Where: C is consumption expenditure, S is personal saving and Yd is disposable income

Activity 2.1

Discuss the following points with your partner(s).

1) Is there any difference between what you think about the elements or components of
national income before and after you have studied this section? If so what are the
differences?
2) If Mr. an American investor producing in Ethiopia, in which country’s GNP do you
think will his output, revenue or profit will be recorded?

28
3) In Question -2, in which country’s GDP do you think will Mr. Wiliams’ output, revenue
be recorded?
4) Try to recalculate the above simple examples by taking your own values or
figures/numbers.

Exercise 2.1

Attempt the following questions

1) Explain the difference between Gross Domestic Product (GDP) and Gross National
Product (GNP).
2) Given the following information on national income accounts of Ethiopia, then answer
the questions that follow.
Gross Domestic Product (GDP) = 200 million Birr
Gross National Product (GNP). = 188 million Birr
Capital Consumption Allowance (Depreciation) = 10 million Birr
Then:
a) Calculate Net Domestic Product (NDP)
b) Calculate Net National Product (NNP)
c) Calculate Net Factor Payment (NFP)
d) What do you conclude from the sign (positive or negative) of Net Factor Payment
(NFP)?
3) What do you call the difference between what foreigners receive here in Ethiopia and
what Ethiopians receive abroad?
4) Define and differentiate among the following macroeconomic models:
a) Two sector model
b) Three sector model
c) Four sector model
d) Open economy model
5) Match the values in column A with those under column B.

“A”
1) Elias, producing in Kenya

29
 2) Amarech, Ethiopian producing in Ethiopia
3) Ahmed, Ethiopian producing in USA
4) Sofia, American producing in Ethiopia
5) Chala, Ethiopian producing in Ethiopia
6) Charles, South African producing in Ethiopia
“B”
a) Ethiopian Gross domestic Product (GDP)
b) Ethiopian Gross National Product (GNP)
c) Kenyan Gross Domestic Product (GDP)
d) USA Gross National Product (GNP)
e) South African Gross National Product (GNP)
6) Given:
National Income (NI=Y) = 300 million Birr
Net transfer payments (TR) = 80 million Birr
Total Taxes (T) = 90 million Birr
Total consumption expenditure(C) = 190 million Birr
Then:
a) State the relationship between disposable income, saving and consumption
b) Find disposable income (Yd)
7) Define the following national income accounts and provide examples for each case.
A) disposable income (Yd)
B) retained earnings
C) subsidies
D) transfer payments
E) Depreciation or Depreciation allowance
F) Personal saving
8) What are the precautions we have to make in measuring GDP, GNP or related to national
income account elements?
9) List the major differences between consumer price index (CPI) and GDP deflator. What
do these differences implicates? Discuss your views with your partner(s).

30
1.6 Approaches to ‘National Income Accounting’ process

There are three major approaches/methods of measuring GDP or GNP. These are:

1. The value added approach;

2. The expenditure approach; and

3. The income approach.

In all these approaches, we use the idea of fundamental national income accounting identify
given by: Y = C + I + G + NX given that the economy is open.

1.6.1 Value added approach

According to the value added approach to national income accounting process, the total output of
a country, Gross domestic Product (GDP) is obtained by adding the new values of goods and
services created at different stages of process or in different sectors. Only the value added at each
stage of process in different sectors is recorded.

For instance, take one “quintal” of wheat, costing 200 Birr in the farm. In the process of making
sandwich from the wheat cereals, the following should be recorded at each stage.

Table 2.2: Computing Value added in production

Stage of process Total value of the quintal Value added(in

wheat at each stage (in Birr) Birr)

Wheat at farm 200 200

Wheat in the market including 250 50

transportation

Wheat flour in the market 310 60

31
Bread in the market 460 150

Sandwich at cafeteria 530 70

If all process are undertaken in same year 530

If the was produced one year earlier it would be recorded in GDP of that year, so that this year
income or GDP includes only 330 Birr. That is, we exclude the value of wheat at farm (200 Birr)
since it should be recorded in the GDP of previous year. Such record must be made for items
produced in different sectors of the country.

It should be stressed that it would be difficult to record everything at every stage. That means
this method involves very complex steps at it involves continuous recordings from time to time
carefully. Since the value of the item should be recorded several times (at different stages of
production process), this method is very prone to error of double recording. Because of this
defect this method is not frequently used. Instead the other two approaches i.e. expenditure
approach and income approaches are widely used.

1.6.2 Expenditure Approach

In expenditure approach, the total output of a country, gross domestic product (GDP) is
measured as the sum of expenditures made in all sectors of the country. All expenditures of the
various sectors of the economy are added to know GDP. The underlying assumption of using
expenditure in measuring income is that the expenditure of one sector or person is the income of
the other (receivers of that money spent by other sectors). Thus, the national income identity is
given as follows:

Where; GDP=Y= Gross Domestic Product/Income

32
 C= Personal consumption expenditure

I= Gross private domestic investment expenditure

G= Government expenditure

NX= Net export (Export (X) minus Import (M))

NX= X-M

Export (X): represents foreign expenditure on our goods and services which should be added on
our national income while imports (M) represents our expenses on foreign goods and services
which overstate our output to be deducted from the national income.

Personal consumption expenditure (C) accounts for the largest portion of GDP, including
expenditure on final goods, durable and non-durable consumption goods. For instance, these
include expenditure on food, vehicles, and so on.

Private domestic investment expenditure (I) includes expenditure on raw materials (factors of
production) and final goods such as capital investments to generate more output. These include
land, labor, machineries, buildings, inventories of unsold goods (for merchants) and so on. Note
that replacement of old machinery represents a negative value in national income because it is
nothing but depreciation.

Government expenditure (G) represents all expenditure on goods and services by government
on behalf of the nation. For instance, government provides citizens with privately non-marketed
goods like security. This includes goods of immediate consumption (car, planes, stationary etc.),
investment goods (buildings and machineries for production purpose) and so on.

Example:

Given the following summarized information about the values of national output, we can
calculate the value of total output (GDP) of the country as follows.

Table 2.3: GDP using expenditure approach

33
Components Value In Birr

Personal consumption expenditure (C) 11,400

Private domestic investment expenditure (I) 6,500

Government expenditure (G 7,300

Export (X) 900

Import (M) (1,100)

Total Expenditure(=national income/output, GDP) 25,000

The value of GDP in above example is calculated by summing up the first four items and by
deducting the fifth item that is imports (M). Thus:

GDP = Y= C + I + G + X - M

GDP = 11,000 + 6,500 + 7,300 + 900-1100

GDP = 25,000

Note that we are using the aggregated or summarized figures of values of the national output in
the above example. This means that we should note that each value given in the Example has its
own importance and estimated differently. For instance, there are different components of
government expenditure such as current expenditure and capital expenditure, its expenditures in
different sectors (in agriculture, on health, on education etc.).

34
 1.6.3 Income Approach

When we use the income approach to measure GDP or GNP, we add up all the incomes earned
by different factors of production: land, labour, capital and so on. Thus, the following relation
gives the national income identity.

Where,

GNP = Y = Gross national product,

W = Wages of all workers (compensations of employees),

R = Rents paid to property owners (reward for services),

I = Interest on borrowed capitals,

Π = Profit of business organizations,

IT = Indirect business taxes and

D = Depreciation (Capital consumption allowance)

35
Profit (Π) include dividends and retained earnings of corporate organizations; proprietors'
income and so on. Indirect taxes (IT) are said to be indirect because consumers pay it indirectly.
When we calculate total national output, GDP, or GNP we take different taxes as positive as it is
income of the government.

Note that in some cases, the depreciation element is considered or used only in calculating NDP
or NNP which, we discussed in earlier sections.

Example: given the following information about the values of some national income accounts,
GDP can be calculated as follows, using the income approach to national income accounting
process.

Table 2.4: GDP using Income Approach

Income Components Value (in million Birr)

Compensations of employees (W) 14,750

Rents paid to property owners (R) 1,090

Interest on borrowed capitals (I) 2,180

Proprietors incomes 2,040

Retained earnings 1,800

Dividends 1,720

Corporate income taxes 1,670

Indirect taxes 2,500

36
Depreciation allowances (2,750)

Total Income = GDP = Y 25,000

The above values are calculated by summing up all values given above, except depreciation that
is deducted from the total.

GDP = Y = W + R + I + II + IT –D

= 14,750 + 2,180 + 1, 090 + 2,180 + (2,040 + 1,800 + 1,720 + 1,670 + 2,500) – 2,750

GDP = 25, 000(in million Birr) = 25 billion Birr

Note that in this calculation all the values in the parenthesis are components of the profit of the
business organizations. Moreover, the values of taxes are added when calculating the value of
GDP because it is the income of the government sector. Not also, that in some texts deprecation
allowance is considered or deducted only to calculate net GDP or net GNP.

Activity 2.2

Discuss the following issues.

 What new ideas have learnt in this section?

 Which of the above methods of measuring national output is the best method? Why?
 In what category of national income account elements of expenditure approach do you
think is your personal daily expenditure included?
 If it is covered by the Ethiopian government under what category of national income
account elements of expenditure approach do you think is the expenditure used to
construct the road connecting Harar to Addis Ababa included?
 Under what category of national income account elements of expenditure approach do
you think is the yearly defense expenditure included?

37
 Exercise 2.2

1) Define the concept of “National Income Accounting”.

2) Explain briefly the following three major approaches to measuring national output.
a) Income Approach
b) Expenditure Approach
c) Value Added Approach
3) Differentiate between the national income identity in expenditure approach of a closed
economy and that of open economy.
4) List and briefly explain the major weaknesses of Gross Domestic Product (GDP) or
Gross National Product (GNP) as measure of performance of a given economy.
5) Given the following information about the values of national output, calculate the value
of the total output (GDP) of the country.

Components Value in Birr

Personal Consumption Expenditure (C )

Durable goods 4,200.00

Non-durable goods 7,700.00

Gross Private Domestic Investment (I)

In agriculture 6,000.00

In trade 5,000.00

Government Expenditure

38
 On defense 7,300.00

Other public services

a) Current expenditure 3,000.00

b) Capital expenditure 7,000.00

Exports (X) 1,000.00

Imports (M) (1,400.00)

Expenditure( = national income/output, GDP) ?

6) Which of the above discussed three major approaches to national income accounting
process is least used? Why?

1.6.4 The Drawbacks/Shortcomings of GDP and/or GNP

1. The figure of GDP or GNP does not tell us the long-term sustainability of gains from
production. These values do not tell us whether the current trend of growth is going to
continue in the future.
2. The values of GDP and/or GNP do not indicate composition of national outputs.
3. Relative improvement in quality of some items and relative growth in some sectors is not
known from the value of GDP or GNP.
4. Income distribution is not known from the figure of GDP or GNP.
5. GDP or GNP accounts only for marketed transactions. Some economic activities have no
place in market. Some of these activities are home based activities such as cooking, child
caring, homemade laundries and so on. Goods and services that are not marketed are not
included in GDP or GNP.

39
 6. GDP or GNP ignores underground economy.
7. The side effects of economic growth on environment are not accounted for by GDP or
GNP.
8. GDP or GNP is again very difficult for international comparison. This is because
countries’ GDP or GNP are calculated using their respective countries currencies. One
US dollar is not equal to one Ethiopian Birr. Even after changing to similar currency, it is
difficult to compare GDP and GNP because price of commodities are different in
different countries and thus cost of living are different in different countries.

Self- Assessment Test 2.2

Please put a tick mark (√) or (X) in front of the activities to confirm whether you can or cannot
perform/understand the listed activities.

1) Can you list three approaches to measuring national income accounting process? --------□
2) If you are given necessary data, can you calculate the value of GDP:
a) Using expenditure approach -----------------------------------□
b) Using income approach ----------------------------------------□
c) Using value added approach -----------------------------------□
3) Can you distinguish at least five shortcomings of GDP and of GNP as measurement of
economic performance? ------------------------------------------------------------□
4) Can you distinguish between elements of GDP and of GNP in national Income
accounting process? -------------------------------------- □
5) Can you describe why we should make some caution in national income accounting
process or in measuring GDP? -------------------------------□

If more than one of your responses above questions are “not ticked’’, please go back and re-
read the above lessons.

40
 Unit Summary

In this unit, our attention was on national income and its accounting process. We discussed about
methods of measuring the value of total output of a country called ‘national Income accounting’
process and related concepts.

National Income Accounting process refers to the process of record keeping for the overall
economic activities (goods and services) of a given country in a year. It is the process of
measuring national output, Gross Domestic Product (GDP) or Gross National Product (GNP).

From the point of view of the number of sectors involved in the analysis or in the model, there
are three major macroeconomic models: Two-sector model, Three-sector model (Closed
Economy model), Four-sector model (Open Economy model).

Two sector model represents the case where there are only two (household sector and the firm)
sectors in the economy.

Three-sector model also known as closed economy, incorporates government sector. Therefore,
household, firms or the business sector and government are the three parties involved in the
economy.

The four sectors, in addition to the three-sector model, includes trade with other countries. As a
result, the elements of trade such as import and export are incorporated in the model.

Nominal GDP is the value of all final goods based on the prices existing during the time period
of production. Nominal GDP can grow in three ways: When output rises and a price remains
constant; Prices rises and output remains unchanged; and When both prices and output rises

Real GDP is the value of all final goods produced during a given time period based on the prices
existing in a selected base year. Real GDP is also known as GDP in constant price or Birr. It is
GDP adjusted for inflation. The adjustment factor is known as GDP deflator. The GDP deflator
and consumer price index are indexes measure of change in the general price level. GDP deflator
is the ratio of nominal GDP to real GDP.

41
Gross domestic product (GDP) is the sum of values of goods and services produced in the
country by citizens of the country and foreigners. Therefore, GDP is something related to
territory of the country (i.e. GDP is territorial) whereas GNP is something related to citizenship
(i.e. GNP is national). The difference between GNP and GDP equals to the net income earned by
foreigners (NFP).

In measuring GNP and/or GDP, money must be used as common unit of measurements; Market
values of goods and services should be applied; only final goods and services should be
considered or included in the calculation of GDP; Non-productive transactions should not be
included in GDP; Products in informal sectors should be included in GDP

The difference between GDP and GNP is equal to or the same as the difference between NDP
and NNP.

National income (NI or Y) is the difference between Net National Product (NNP) or Net
Domestic Product (NDP) and Indirect Taxes (IT).

Personal income (PI) is the value of personal income (PI) is the net value of national income
and different personal payments and receipts.

Disposable income (Yd) is the amount of income that is left for a person after payment of any
taxes and transfers.

Personal savings (S) is the amount of disposable income that is left over and above consumption
expenditure.

There are three major approaches/methods of measuring GDP or GNP. In all these approaches,
we use the idea of fundamental national income accounting identify given by: Y = C + I + G +
NX given that the economy is open.

According to the value added approach to national income accounting process, the total output of
a country, Gross domestic Product (GDP) is obtained by adding the new values of goods and
services created at different stages of process or in different sectors.

42
In expenditure approach, the total output of a country, gross domestic product (GDP) is
measured as the sum of expenditures made in all sectors of the country.

In income approach to measure GDP or GNP, we add up all the incomes earned by different
factors of production: land, labour, capital and so on.

The Drawbacks/Shortcomings of GDP and/or GNP are: it does not tell us the long-term
sustainability of gains from production, it does not tell us whether the current trend of growth is
going to continue in the future, it does not indicate composition of national outputs, it doesn’t tell
us relative improvement in quality of some items and relative growth in some sectors, income
distribution is not known from the figure of GDP or GNP, GDP or GNP accounts only for
marketed transactions, GDP or GNP ignores underground economy, the side effects of economic
growth on environment are not accounted for by GDP or GNP, GDP or GNP is again very
difficult for international comparison.

Self-Test 2

Choose the best answer that bears the best answer

1) Which of the following statement is true?

A) GNP is national whereas GDP is territorial
B) GDP is national whereas GNP is territorial
C) GDP usually measures non-marketed goods
D) GNP includes non-marketed goods
E) All of the above
2) Which of the following national income account element is the smallest?
A) Gross Domestic Product (GDP)
B) Gross National Product (GNP)
C) Net Domestic Product(NDP)
D) National Income (NI)
E) Disposable Income (Yd)
F) None of the above

43
 3) All except one of the following are not element of national income identity in expenditure
approach to national income approach?
A) Retained earnings
B) Employees compensation ( or wage income)
C) Proprietors’ income
D) Private investment spending
E) Interest income

Given the following information about an open national account figures in 000’s, answer
questions from 4 to 6

Total private consumption expenditure = 4000 Birr

Total private investment expenditure = 3000 Birr

Total Government expenditure = 5000 Birr

Net Export = 1000 Birr

Total Import = 3000 Birr

4) What is the value of Gross Domestic Product (GDP)?

A) 16,000 Birr
B) 13,000,000 Birr
C) 14,000 Birr
D) 20,000 Birr
E) 16,000,000 Birr
F) None of the above
5) What is the value of Gross Domestic Product (GDP) in 000’s?
A) 14,000 Birr
B) 13,000,000 Birr
C) 16,000 Birr
D) 20,000 Birr
E) 16,000,000 Birr

44
 F) None of the above
6) What the value of total Export?
A) 4,000 Birr
B) 4,000,000 Birr
C) 1,000 Birr
D) 2,000 Birr
E) 6,000,000 Birr
F) None of the above
7) Which of the following is true about the drawback of GDP as measure of economic
performance?
A) GDP does not show income distribution
B) GDP does not measure non- marketed items or product
C) GDP does not account for the leisure time
D) GDP does not account for the side effect of production on the environment
E) GDP does not depict sustainability of existing economic performances
F) All of the above
8) Arrange the following national income account from the smallest to the largest
( according to increasing in scope of the concept)
A) Gross Domestic Product (GDP)
B) Gross National product (GNP)
C) Net Domestic Product (NDP)
D) National Income (NI)
E) Disposable Income (Yd)

Suggested References

Ackley, G. (1987) Macroeconomics. Theory and Policy, New York, McMillan Publishing

Mankiw, G, (1997). Macroeconomics, (3rd ed.), New York, Worth Publishers

Olney, M. (2002), Microeconomics, Study Guide, New York University of California, McGraw-
Hill/Irwin.

45
R. Dornbusch, Fisher, S and Richard, S. (1999) Macroeconomics, (7 th ed.), New York, McGraw-
Hill International edition.

Shapiro, E. (2000) Microeconomic Analysis, (5th ed.), New York, Harcourt Brace Javinovich,
Inc,

UNIT THREE: ECONOMIC PERFORMANCE AND BUSINESS CYCLE

3.1 Introduction

Dear learner, we have seen different measures of economic performance (such as GDP/GNP)
and related concepts in the last chapter. But, such measures indicate only the performance of an
economy at a time (a given year) while what is more important to make macroeconomic analysis
is the trend of these figures over time. The level of overall economic activity, say as measured by
GDP, fluctuates around the full employment level of output from time to time. Such fluctuations
are the results of certain factors and every phase in the fluctuation process have certain
characteristics. Macroeconomists are well interested in explaining the full employment level of
output given the available resources in the economy at any time, why the economy fluctuates
around the full employment level of output and what characterizes the different phases of the
fluctuation process. These interesting macroeconomic issues are mostly explained using the
concept of the business cycle.

Dear learner, this chapter is aimed to introduce you with the concept of the business cycle and
the different theories explaining it. The chapter has two sections. Specifically, the first section of
the chapter will present you the definition and basic concepts of the business cycle, the different

46
phases of the business cycle along with their characteristics, factors attributed for the fluctuations
in the economy, and related issues. The second section of the chapter will discuss the different
theories of the business cycle.

3.2 Learning Objectives:

At the end of this unit, you are expected to be able to:

 Define the business cycle;

 Enumerate the different phases of the business cycle;

 Explain the characteristics of the different phases of the business cycle;

 Explain the causes of the different phases of the business cycle;

 Distinguish between potential and actual output; and

 Define the output gap.

 List the major business cycle theories;

 Discuss each business cycle theory;

 Compare and contrast the different business cycle theory; and

 Distinguish between lead indicators and lag variables.

3.3 Key Concepts for Review

Boom Potential out put

Recession Actual output

Bottom Trend path

Recovery Aggregate demand/spending

Output gap Aggregate supply

47
Money supply Lead indicators

Propagation mechanism Lag variables

3.4 The concept of the business cycle

Dear learner, one of the major concerns of macroeconomics is the upswing and downswings in
the level of real output. Such upswings and downswings are conceptualized using the business
cycle whose discussion is of great importance to know the position of an economy in the
business cycle and forward the appropriate policy packages. Therefore, this section discusses the
basic concepts of the business cycle that help us address the section objectives given hereunder.

3.4.1 Definition and Concepts of the Business Cycle

Dear learner, the business cycle can be defined as a more or less regular pattern of path
fluctuating with the level of economic activity of an economy around the trend path. It shows
alternating periods of economic growth and contraction, which can be measured by the changes
in real Gross Domestic Product (RGDP). The total national output of a country changes from
time to time depending on different negative and positive factors. The negative factors are those
which adversely affect total national output. For instance, drought reduces agricultural outputs;
wars divert resources from production to war and inappropriate economic policies mislead
countries economic growth path thereby leading to fall in total national output. The fall in total
output is represented by the downward moving path of the business cycle.

Positive factors increase the total national output. For instance, favourable climate conditions
increases agricultural output; political stability also helps people concentrate on production and
government use resources for production and good trade polices enable a country to get more
foreign exchange. These all increases total output (values of goods and services) of a country.
This increase in economic performance is depicted by the increasing path of the business cycle.

Since economic variables are related, any change in real Gross Domestic Product (RGDP) brings
similar changes in employment, trade and other key indicators of the economy. In other words,
all other aggregate economic activities get affected. The upswing and downswing in the level of
real output are cyclical in nature and move around its trend path. The trend path is given by

48
straight-line that shows the movement of the economy if it is in full employment. In other words,
the trend path of aggregate economic activities is the normal path the indicators (GDP,
employment, trade, Growth etc.) would take if factors of production were fully employed.

3.4.2. Phases of the Business Cycle

The business cycle has four different phases. These phases are stages through which an economy
passes to complete one full cycle. Namely, these phases of the business cycle are Peak (Boom),
Contraction (Recession), Trough (Bottom) and Expansion (Recovery). Once completed,
these phases repeat themselves. That means, the sequence of changes in the business cycle is
recurrent but not periodic and varies in duration. The duration depends on factors like good or
bad economic policies and favourable or unfavourable natural conditions. However, the different
phases come one after another in the same sequence in all cycles. We can clearly represent this
sequence of different phases of the business cycle in the following way:

Boom Recession Bottom Expansion Boom ………

This sequence repeats itself in different length of periods for different economies or different
countries. From Boom to Recession, Bottom then Expansion, again to Boom, Recession and so
on. Normal business cycles vary from one year to ten or twelve years. They represent a rise and
fall of a nation’s economic activities, such as GDP or GNP, inflation, growth and unemployment.
Contraction or recession follows bad economic policy (national or international) and bad natural
or social factors likes drought or conflict whereas expansion or recovery follows the opposite
factors like good economic policies or favourable natural factors.

During peak, economic activities reach their maximum after rising during a recovery. In
recession or contraction, generally economy witnesses a downturn in the business cycle during
which real GDP declines. During trough economic activities reach its minimum after falling
during recession. Recovery represents an upturn in the business cycle during which real GDP
rises. One can observe similar patterns in other economic indicators such as inflation, growth,
unemployment etc. The business cycle is depicted in the following figure (Figure 3.1). In the
figure, X-axis represents the time period and Y-axis represents the aggregate economic activities.

49
 Trend Line is indicated by the straight dotted line and business cycle which passes through
points of actual economic activity measured by GDP is shown by bold line.

Figure 3.1: Business Cycle

Y
Peak

Aggregate
Economic Peak
Activities P1 Trend Path

B
Contraction

Expansion
Expansion
O P1 X
Time
From ‘O’ to ‘P1’ in the figure, one can find that economy is moving upwards on the business
cycle. This phase is therefore, known as Expansion phase. Economy reaches its peak, which is
at point ‘P1’. From ‘P1’ to ‘T’ economy is in recession, which means economic activities are
slowing down. This trend is shown by the downward movement of the cycle. This phase is
known as Contraction phase. The figure depicts that contraction phase brings or leads to the

50
bottom of the economic activities, which is known as trough represented by point ‘T’. From the
figure one perceives that from bottom point the economy again starts recovering because of some
corrective measures or favourable conditions created for the economy; i.e. expansion phase
begins. This process continues again that is by reaching peak followed by trough.

We hope that you are getting the ideas discussed above. Let us quickly complete the following
activity in order to understand better and prepare for the next topics.

Activity 3.1

a) What expansionary and contractionary periods can you mention in the history of
Ethiopian economy? Please share and discuss your answer with your partner.

b) Do you think our economy currently is in expansion or contraction? Why? What do

you think are the reasons? Please share and discuss your answer with your partner.

c) What do you think the output gap in the Ethiopian economy currently is? Positive,
negative or zero? Why? Please share and discuss your answer with your partner.

Dear learner, have you completed the above activities? Good! Now let us proceed to the next
topics.

3.4.3. Business Cycle and Output Gap

Trend path is the level corresponding to full employment of the factors of production but actual
output fluctuates around the trend level. During expansion the employment of factors of
production increases, and that is a source of increased production. Conversely, during recession,
unemployment increases and the output produced is below its capacity. Deviation of output from
trend is known as output gap. The output gap measures the gap between the output the economy
could produce at full employment (trend line) given the existing resources and actual output
(cyclical line). Full employment output is called potential output. Output gap is the difference
between potential output and actual output.

Output Gap = Potential Output (Trend) - Actual Output (Cyclical)

51
 = Yt - Ya

Where; Yt is trend or potential output and Ya is actual output or cyclical output

There are three possibilities of output gaps. That means the output gap can take three different
values: Positive, negative or zero; based on the actual magnitude of trend and cyclical output. A
negative gap indicates that there is over employment, overtime for workers, more utilization of
the capacity of the machineries and so on. Positive Output gap indicates under-employment,
underutilization of capacity and actual output falls below the potential output. And zero output
gap indicates that the economy is at full employment of the existing factors of production.

Exercise 3.1

1. Define the business cycle.

2. List out the four phases of the business cycle and briefly describe each.

3. What are the major factors that give rise to economic expansion? Discuss.

4. What is the difference between potential output and actual output?

5. During recession, an economy witnesses an increase in unemployment.

a) True b) False

6. The output gap along the trend path is zero.

a) True b) False

Did you find difficulties in solving the above exercises? If yes, please go back and re-read
thoroughly the discussions made.

Self-Assessment Test: 3.1

52
Dear learner, please put a tick mark (√) or (x) in front of the activities to confirm whether
you can or cannot perform/understand the listed activities. I can:

1) Define the business cycle --------------------------------------------------------------------□

2) Enumerate the causes of the different phases of the business cycle ------------------□

3) Enumerate and characterize the different phases the business cycle -------------------□

4) Define the output gap ------------------------------------------------------------------------□

5)Distinguish between potential output and actual output ------------------------------□

! If more than one of your responses to the above questions is ‘Negative or not ticked”,
please go back and re-read the above lesson and discuss with partner.

3.5 Theories of the Business Cycle and Indicator Forecasting

Dear learner, the uneven historical pattern of economic growth gives rise to the question about
the factors that cause the business cycle. Many theories have been developed to explain the
business cycle and give answer to the questions being raised. However, no single theory has had
outstanding success in explaining and successfully predicting the business cycle. In fact, the
theories, altogether, provided important explanations that build the concept of business cycle.
Most of the theories concentrate on Aggregate Demand and Aggregate Supply (AD-AS) model.
These include:

 The Keynesian theory  Real Business Cycle Theory

 The monetarist theory  Political Business Cycle

 Rational Expectation Theory

Dear learner, this section of the chapter will introduction of indicator forecasting at the
present you discussion of the above business end of the section. Enjoy.
cycle theories one by one and brief

53
3.5.1. Theories of the Business Cycle

1) Keynesian theory

Keynesian theory holds that changes in aggregate spending are the cause of variations in real
GDP. Let’s take a simple example by assuming an open economy model which divides the
economy in to four sectors namely the household, business, government and foreign sectors. In
this model, the household sector makes consumption expenditures (C), the business sector makes
investment expenditures (I), the government makes government expenditures (G) and the foreign
sector makes expenditures on the country’s exports which is taken net of imports by the domestic
economy (X – M). The aggregate spending includes the sum of the spending by all these four
sectors which is equal to the GDP of the economy according to the expenditures approach to
national income accounting process as discussed in the previous chapter. Mathematically, we can
represent this relationship by the national income identity as follows:

Now, we can understand why changes in total spending make the level of GDP to change as
well. If the total spending increases, business firms find it profitable to invest and increase
output. When business firms increase the output, they use more land, labour and capital. Hence,
increased spending leads to increase in output, employment and incomes, thereby leading to
expansion or recovery phase of the business cycle. When total spending falls, however,
businesses or producers will find it more profitable to produce a lower volume of goods and
services and avoid inventory. This is because; there is low demand for their products. In this
case, output, employment and income falls. This leads to recession.

2) Monetarist Theory of Business Cycle

In this theory, a fluctuation in the money stock is the main source of economic fluctuations. The
impulse in the monetarist theory of business cycle is the growth of the quantity of money. An
increase in the money supply brings expansion and a decrease in money supply brings recession.
When the money growth rate increases, the quantity of real money circulating in the economy
also increases. At the same time, the supply of real money balances increases and the interest rate
falls. The foreign exchange rate also falls. These initial financial market effects begin to spread

54
to other markets that investment demand and exports will increase, and consumers spend more
on the durable goods. These changes have multiplier effect and finally aggregate demand curve
shifts to the right from AD1 to AD2 and brings expansion. Please see the figure below.

Assuming upward slopping supply curve, a rightward shift in aggregate demand brings not only
an increase in GDP, but also the price level. Similarly, one can analyse for a decrease in the
money supply and show its result is recession or trough of the business cycle.

Figure 3.2; Money Supply and Aggregate Output

AD2
AS
Price
AD1

P2

P1

O Y1 Output (Y)

3) Rational Expectation Theory

A rational expectation is a forecast that is based on the available and relevant information.
According to this theory, an anticipated fluctuation in aggregate demand has no impact on
economic performance. It is unanticipated changes in aggregate demand that bring fluctuation
which leads to business cycle. A larger than anticipated increase in aggregate demand brings
expansion whereas a smaller than anticipated increase in aggregate demand brings a recession.

55
When aggregate demand decreases, if money wage doesn’t change, then real GDP and price
level decreases. The fall in price level in turn leads to an increase in the real wage rate and
unemployment rate. These changes in the economy lead to recession. This is because when
prices fall producers become less profitable and they thus cut their production and reduce their
workers. This happens if the decrease in aggregate demand is unanticipated.

4) Real Business Cycle Theory (RBC)

Real Business Cycle Theory asserts that fluctuations in the output and employment are due to a
variety of real shocks that hit the economy. According to this theory markets adjust rapidly due
to these shocks and always remain in equilibrium. These real shocks are basically due to random
fluctuations in productivity. Scholars who belong to this theory assume that random fluctuations
in productivity are the result of fluctuations in the pace of technological changes, international
disturbances, climatic changes and natural disasters.

Disturbances are due to the shocks to productivity, supply shocks and shocks to government.
This thereby asserts that productivity shocks are due to change in weather and new method of
production. For example, if due to favourable productivity shocks people want to take advantage,
they would work hard to increase their output. They also invest more capital to spread the
productivity shock into future periods by raising the stock of capital leading to cyclical
expansion or peak.

The shocks due to the disturbances are spread through the economy. This principle is known as
propagation mechanism. This propagation mechanism basically tries to explain why people
work more sometimes than during other times.

5) Political Business Cycle

Another explanation is where government deliberately causes business cycle. This situation is
known as political business cycle. It refers to a business cycle, which is caused by policy makers
to improve re-election chances. Governments adopt tight monetary and fiscal policy soon after
an election, but then adopt more expansionary policies as the election approaches to encourage a
‘feel-good’ factor. This theory views politics to be a short-run game where the self-interest of the
politicians is to maximize votes. Voters are also short sighted and want good news now rather

56
than being promised. For example, just prior to election if a politician comes with attractive
benefits for the voters then he is likely to be favourite candidate. This is due to the reason that
voters are short-sighted.

The difference of this theory of creating recession from other theories is that political business
cycle is deliberate and created by politicians while other theories are not deliberately created. In
case of developing countries, business cycles have not received much attention. This is because
the cyclical movements are caused by highly unpredictable factors like droughts, famine and
contraction of exports. These factors are mostly natural or an act of god. In such cases, the study
or forecasting of business cycle becomes an extremely difficult task.

We hope that you are getting the ideas discussed above. Let us quickly complete the following
activity in order to understand better and prepare for the next topics.

Activity 3.2

a) What factors can you mention that cause economic fluctuation, say the recent growth
in Ethiopia? Please share and discuss your answer with your partner.

b) Have you ever noticed any of the above theories of business cycle apply in the case of
Ethiopia? Which ones? How? Please share and discuss your answer with your
partner.

Dear learner, have you completed the above activities? Good! Now let us proceed to the next
topics.

3.5.2. Forecasting Business Cycle: Indicator Forecasting

As we know, economic variables are inter-related and they show cyclical movements. Some of
these variables or indicators are known as lead indicators. These lead indicators’ turning points
occur before those of total economic activity. For instance, capacity utilization of manufacturing
sector, residential construction, stock prices etc. start turning up and down before aggregate
economic variables like changes in GNP and employment. This means that a stimulation of large
scale residential construction leads to increased demand for construction materials. This will then

57
contribute to boosting in production and income of the sector, which in turn adds to cyclical
expansion.

Variables like industrial production and business expenditures roughly coincide with the overall
cycle. Whereas some other variables like job vacancies and unit labour costs, called lag
variables, lag behind the business cycle. Monitoring lead indicators can give advance warning
about the turning points in the economic activity. Thus, the country can take corrective measures
to avoid recession. In other words, appropriate policy in the right time may help the country to
overcome the problems associated with the business cycle. One should aware that in addition to
output, unemployment and inflation can be used as measures of fluctuations in an economy and
these issues will be discussed in the last chapter of this course.

Exercise 3.2

1. What is the cause of economic fluctuation in the political business cycle?

2. List out at least three examples of lag variables in an economy.

3. What is the difference and similarity between the Keynesian and Monetarist theories of
business cycle?

4. What is the importance of lead indicators in an economy?

Did you find difficulties in solving the above exercises? If yes, please go back and re-read
thoroughly the discussions made.

Self-Assessment Test: 3.1

Dear learner, please put a tick mark (√) or (x) in front of the activities to confirm whether
you can or cannot perform/understand the listed activities. I can:

1) Explain the different business cycle theories---------------------------------------------□

2) Compare and contrast the different business cycle theories ---------------------------□

58
3) Distinguish between lead indicators and lag variables------------------------------------□

4) Explain the propagation mechanism--------------------------------------------------------□

5) Enumerate at least three of the major measures of economic fluctuation---------------□

! If more than one of your responses to the above questions is ‘Negative or not ticked”,
please go back and re-read the above lesson and discuss with partner.

59
Have you completed the above part? Good! Now it is time to complete the following self-test
exercise. Good luck! If you face any difficulties, please read the section again.

Self-test 3

1. Identify the one that follows the correct order phases of the business cycle.

a) Boom, Recession, Trough and Recovery.

b) Recovery, Boom, Trough and Recession.

c) Trough, Recovery, Recession and Boom.

d) Recession, Boom, Recovery and Trough.

e) All of the above.

f) None of the above.

2. According to the _____________ theory of business cycle, the cause of variations in real
GDP is changes in aggregate spending.

a) Keynesian theory

b) Monetarist theory

c) Real business cycle theory

d) Political business cycle

e) All of the above

f) None of the above

3. According to the Rational expectations theory, variation in real GDP is caused by:

a) Anticipated changes in aggregate demand

b) Shocks that hit the economy

60
 c) Unanticipated change in aggregate demand

d) Changes in the supply of money

e) All of the above

f) None of the above

4. Which of the following factors may cause an expansion?

a) Good economic policy

b) Political stability

c) Good weather

d) All of the above

e) None of the above

5. A given economy experiences downturns during _______________.

a) Expansion

b) Recovery

c) Peak

d) Recession

e) All of the above

f) None of the above

6. _________________ measures the gap between the output the economy could produce at full
employment given the existing resources and the actual output.

a) Output gap

61
 b) Potential output

c) Real GDP

d) Trend line

e) All of the above

f) None of the above

7. A positive output gap indicates____________________.

a) Underemployment

b) Overemployment

c) Overutilization of capacity

d) None of the above

Unit Summary

One of the major concerns of macroeconomics is the upswing and downswings in the level of
real output. Such upswings and downswings are conceptualized using the business cycle whose
discussion is of great importance to know the position of an economy in the business cycle and
forward the appropriate policy packages. The business cycle can be defined as a more or less
regular pattern of path fluctuating with the level of economic activity of an economy around the
trend path. It shows alternating periods of economic growth and contraction, which can be
measured by the changes in real Gross Domestic Product.

The business cycle has four different phases, namely Peak, Contraction, Trough and Expansion.
These phases are stages through which an economy passes to complete one full cycle. They
represent a rise and fall of a nation’s economic activities, such as GDP or GNP, inflation, growth
and unemployment. Contraction follows bad economic policy and bad natural or social factors
likes drought or conflict whereas expansion follows the opposite factors like good economic
policies or favourable natural factors.

62
Many theories have been developed to explain the business cycle. Most of the theories
concentrate on Aggregate Demand and Aggregate Supply model. Among these, the Keynesian
theory holds that changes in aggregate spending are the cause of variations in real GDP. The
impulse in the monetarist theory of business cycle, on the other hand, is the growth of the
quantity of money. For, the rational expectation theory, it is unanticipated changes in aggregate
demand rather than anticipated changes in aggregate demand that bring fluctuation which leads
to business cycle. Similarly, the real business cycle theory asserts that fluctuations in the output
and employment are due to a variety of real shocks that hit the economy. Another explanation is
where government deliberately causes business cycle which is known as political business cycle.
However, there is no single complete theory that has had outstanding success in explaining the
business cycle. These theories rather build one another and provided important explanations of
the concept of business cycle, altogether.

Suggested References

Branson W. (1989), Macroeconomic Theory and Practice, Third edition, New York Harper and
Row Publishers

Edward Shapiro; Microeconomic Analysis (2000), 5th Edition, Harcourt Brace Jovanovich, Inc,
New York.

Gardner Ackley; Macroeconomics. Theory and Policy, 1987, McMillan.

Gregory Mankiw; (2000), Macroeconomics. Worth publishing.

R. Dornbusch and S. Fisher; Macroeconomics (1994) 2nd Edition, or any other edition, New
York, McGraw-Hill International Edition.

63
UNIT FOUR: CONSUMPTION SPENDING

4.1 Introduction

Dear learner, we have seen some basic definitions and concepts of macroeconomics in the
previous chapters. There, the basic definitions of some macroeconomic variables were presented
and particularly the most important measures of national income were discussed along with the
meaning and nature of their fluctuations in an economy. They were essential knowledge to
evaluate, understand and diagnose the performance of an economy. However, proper evaluation,
understanding and diagnosis of the performance of an economy require further knowledge on the
details of the variables that affect it. One of these variables is overall consumption spending
which is mainly governed by the consumption behaviour of the household sector of the
economy. Hence, it is important for us to understand consumption behaviours of the household
sector of an economy since consumption - being an important part of human behaviour -
influences most of the economic activities directly or indirectly.

Dear learner, the present chapter deals with issues related to the consumption spending and/or
behaviour of the household sector. In this chapter, there are two sections presented for you. The
first section is about the relationship between consumption spending and aggregate demand
and/or national income. In this section, you will learn the meaning of consumption spending,
how it affects aggregate demand and how macroeconomics deals with it. The second section
covers the different theories explaining consumption behaviour of the household. In this section,
you will study the major consumption theories basically explaining consumption income
relationship in view of the household consumption behaviour.

4.2 Learning Objectives:

At the end of this chapter, you are expected to be able to:

 define consumption spending;

 discuss the role of consumption spending in aggregate demand;

64
  define the consumption function and discuss its characteristics;

 define the meaning of autonomous consumption, marginal propensity to consume (MPC),

average propensity to consume (APC) and marginal propensity to save (MPS);

 Explain the relationship between consumption and saving.

 explain more about the income and consumption relationship;

 identify and explain the different consumption theories;

 identify factors that determine consumption spending;

 compare & contrast the different consumption theories.

4.3 Key Terms for Review

> Consumption function > Marginal propensity to consume (MPC)

> Average propensity to consume (APC) > Aggregate demand

> Marginal propensity to save (MPS) > autonomous consumption

> Disposable income > Kuznets’s finding

> Relative income > demonstration effect

> Life – cycle hypothesis > Intertemporal consumption

> Permanent income > transitory/temporary income

> Transitory/temporary consumption > consumption time path

> Consumption puzzle

4.4 Consumption Spending and Aggregate Demand

Can you just write about your understanding about consumption in a piece of paper? How do you
think it is related to aggregate demand? Please compare yourself with discussions provided in

65
this section.

Generally, consumption spending or consumption expenditure is defined as the total amount of

income spent on either durable or non-durable consumption goods such as food, shelter (rent),
clothes and cars or transportation. This spending, however, can be considered at macroeconomic
or individual level. The study of consumption spending at macroeconomic level is mainly
concerned with its importance in the aggregate demand. But, in macroeconomic analysis,
government consumption expenditure is included in the government expenditure (G). So, in this
section, we will discuss individuals’ consumption behaviour and we explain the concept at
macroeconomic level (total consumption expenditure of the private sector/household sector).

4.4.1 Consumption and Aggregate Demand: Their Relationship

Dear learner, consumption spending is defined as the total amount of income spent on either
durable or non-durable consumption goods such as food, shelter (rent), clothes and cars or
transportation. This spending can be considered at macroeconomic or individual level. The study
of consumption spending at macroeconomic level is mainly concerned with its importance in the
aggregate demand. But, dear learner, how do you think consumption is related to aggregate
demand?

In order to understand this, let us first discuss the meaning of aggregate demand. In very simple
terms, aggregate demand is the total amount of goods and services demanded in an economy.
The economy can be taken as the combination of several sectors, namely the household sector,
the business sector, the government sector and the foreign sector.

All of the sectors demand goods and services from the economy. The household sector demands
consumption goods and services desired for life. The business sector demands investment goods
required for business. The government sector demands both consumption and investment goods
to facilitate public services, build infrastructure, etc. Residents of the rest of the world also
demand the nation’s goods and services, and so the nation does theirs. The former constitute the
export while the latter constitutes the imports and the difference between them is known as net
export which is a transaction in the foreign sector of the economy. The total amount of goods and
services demand by all of these sectors is known as aggregate demand. It includes consumption

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spending the of household sector (C), investment spending of the business sector (I), government
spending (G) and net of exports (NX) . We can represent aggregate demand in the following
equation.

Aggregate demand (AD) C  I  G  NX

Macroeconomists are always concerned with equilibrium level of output which is that level of
output at which quantity of output supplied is equal to the quantity demanded. As consumption
is the largest component of desired aggregate expenditure, the factors affecting the consumption
are also the most important determinants of aggregate demand and so general equilibrium. As
you may understand from the above aggregate demand function, any change in the factors
determining consumption that produce increase/decrease in consumption expenditure will also
increase/decrease aggregate demand in the economy. Because of this, macroeconomists are
highly concerned with the task of explaining the determinants of consumption spending via a
well-specified consumption function which is discussed below.

4.1.2. The Consumption Function

Consumption function explains the relationship between consumption and income. One of the
popular consumption theories that explain such relationship is known as the Keynesian absolute
income hypothesis. According to this theory when income increases, consumption also
increases linearly. It can also be stated that the current real consumer spending is a function of
current real disposable income. The simple linear relationship is typically represented by the
Keynesian Consumption function that assumes the following relations.

Where: C =Total real consumption of households

a = Autonomous real consumption of households
Yd = Real personal disposable income
c = Marginal propensity to consume (MPC)

Let us understand the meaning of this consumption function and its components. The first
component of the consumption function is the autonomous real consumption of the household

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(denoted by ‘a’) which indicates that even if income is zero, the household will consume
something say by dis-saving or borrowing. The value of autonomous consumption (a) in general
represents the amount of consumption expenditure that consumer(s) make when their income is
zero. This amount may also be obtained from relatives, family, charity organizations and so on.
The other is that part of incremental income spent on consumption which is given by in the
consumption function. This basically depends on the marginal propensity to consume (MPC)
(denoted by ‘c’) which represents the proportion of incremental income that goes to
consumption. It indicates that a person devotes ‘c’ fraction of his/her every incremental income
‘Y’ to consumption. For example, a linear consumption function with MPC of 0.75 indicates that
75 percent of every incremental income of the household will be devoted to consumption and
autonomous consumption of 500 birr indicates that even if income is zero, the households will
consume 500 birr. This condition can be specified as or represented by the following
consumption function:

C = 500 + 0.75Yd --------------------------------------------------- (3.1)

4.1.3. Properties of Consumption Function

The consumption function mentioned above has some related values, such as MPC and APC,
which help to explain more about the characteristics of the consumption function. Based on
Keynes’ absolute income hypothesis this consumption function has the following important
properties:

a) The marginal propensity to consume (MPC) is between 0 and 1, i.e. 0 < c <1

Since marginal propensity to consume (MPC) is the proportion of income that goes to or is used
for consumption, it is easy to conclude that the value of MPC is between zero and one.
Consumers save some proportion of every one unit/dollar of incremental income (according to
the marginal propensity to save) after spending the remaining proportion on consumption. This is
because consumers have to save money for various reasons.

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You may panic that there are overwhelming cases where a consumer spends more than or just all
of its disposable income in consumption. But in that case it means that the consumer have spent
its entire savings on autonomous consumption. This will be clear if we examine how
autonomous consumption is financed. If the income of the consumer is zero, the autonomous
consumption will be financed by borrowing, charity or the combination of these. But as long as
the consumer is earning a positive income, the autonomous consumption will not be financed
through borrowing and charity alone. Rather, part of the autonomous consumption will be
financed from unconsumed part of the disposable income which we may call saving in the form
of reduced borrowing. This will continue until saving becomes more than enough, as income
increases, to pay for the autonomous consumption.

So, if consumption expenditure is equal to or greater than disposable income, then it will only
mean that there is a dissaving or negative saving in the form of borrowing. Hence not all part of
incremental income is going to be spent on consumption which means MPC is less than one. On
the other hand, individuals earn income to finance their consumption. Hence, some proportion of
every one unit/dollar of incremental income will be spent on consumption that is MPC is greater
than zero.

For instance, if we take equation 3.1 as our consumption function then MPC is given by the
slope or the first order derivative of the consumption function with respect to disposable income
(dC/dYd) which is equal to 0.75. It means that if income is increased by $ 1 then the consumption
expenditure of the individual will increase by $ 0.75.

Table 3-1: Allocation of disposable income for consumption and saving

Disposab Consum Saved/ Autono Part of Total Saving MPC APC

le ed Part Remaini mous Autonomous consu / (dC/dY (C/Yd
Income of ng Part consum consumption mptio dissavi d) )
Disposa of ption financed by n ng
ble Disposab Borrowing,

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 Income le charity, etc.
Income

0 0 0 500 500 500 -500 0.75 --

100 75 25 500 475 575 -475 0.75 5.5

1000 750 250 500 250 1250 -250 0.75 1.25

2000 1500 500 500 0 2000 0 0.75 1

3000 2250 750 500 0 2750 250 0.75 0.92

Based on this example you can see how the consumer allocates its disposable income into saving
and consumption, and how it finances the autonomous consumption. When income is zero, the
total consumption is equal to the autonomous consumption and the autonomous consumption is
entirely financed through borrowing which represents a negative saving of $-500. When income
increases to say $1000, the individual spend $750 of it on consumption and uses the remaining
$250 of it to finance part of its autonomous consumption that now it will have to borrow only
$250. You can notice that there is a negative saving of -$250 at this point. But saving has
increased together with consumption in the form of reduced borrowing as a result of the increase
in income. You can observe from table 3.1 that both saving and consumption will keep
increasing as income increases following the same logic. Thus, we can say the MPC lies between
0 and 1 under normal circumstances.

Marginal propensity to consume (MPC) is less than the APC (Average propensity to
Consume).

APC refers to the fraction of total disposable income spent on consumption which can be
calculated as total consumption divided by disposable income (APC = C/Y d). The absolute
income hypothesis implies that MPC < APC. To see why this property holds, it is better to
consider the example of consumption function given above. Assuming MPC is 0.75, table 3.1

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gives the calculations for APC. You can notice in Table 3.1 that all the APC figures are greater
than 0.75. Dear learner, why do you think the MPC is less than the APC? The answer to this
question is that it is because of the existence of some autonomous consumption. Or, in
diagrammatic terms, because the consumption function does not pass through the origin, the
marginal propensity to consume is measured by the slope of the consumption function. However,
the value of average propensity to consume (APC) at a point is measured by the slope of the line
drawn from the origin to the point on the consumption function. The diagram below shows this
situation.

Figure 4.1: MPC and APC

Consumption (C) C = a + cYd

L2 APC CURVE

L1 L3

0 Y1 Y2 Y3 Income (Y)

The slope of the consumption function C = a + cY d measures the MPC where as the slopes of the
lines L1, L2 and L3, drawn from the origin to points on the consumption function corresponding
to level of income Y1, Y2 and Y3, measure the values APC at these level of income. One can
clearly see that the slopes of these lines can only be greater than that of the consumption function
and that they are declining as income increases from Y 1 to Y2 and then to Y3. The implication is
that APC is always greater than MPC and it declines as income increases. If the consumption
function starts from the origin (that is if there is no autonomous consumption), consumption
would be proportional to income and the MPC and APC would be equal (assuming, as before, a
linear relationship). For example, the consumption function might be specified as:

C = 0.75Yd

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Here, autonomous consumption is zero and both the MPC and the APC are equal to 0.75. This
proportional consumption function is important as it will be explained in the next section.

b) The APC falls as Income (Yd) rises

The absolute income hypothesis implies that households spend a smaller proportion of their
income as it increases. This is because all extra income is not going to be consumed. At very low
income a household may consume all of its income which means the saving at such level of
income will be in the form of lower borrowing/dissaving and hence will be spent on autonomous
consumption. Beyond some high level of income at which borrowing/dissaving will be zero,
both consumption and saving will continue to increase with income. In both cases, consumption
increases with income according to the MPC with saving taking different forms to smooth
autonomous consumption, and hence total consumption. After all, it is evident that the existence
of autonomous consumption witnessed the existence of consumption smoothening through
saving which indicates that not all extra income will be consumed.

This is also clear from the first property mentioned above, namely that the MPC is between 0 &
1, that only a fraction of incremental income will be consumed and the remaining will be saved.
Thus, we can conclude that consumption increases by slower rate than income. This implies that
the ratio of consumption to income, which means APC, decreases as income increases. From the
Table 3.1 above, one can clearly see that the greater the level of disposable income, the lower the
APC is. You may also observe from figure 3.1 above that the slopes of the lines L 1, L2 and L3
(Hence the APC at the levels of income Y1, Y2 and Y3, respectively) declines with income.
Correspondingly, the fraction saved or the average propensity to save (APS) must increase with
income (Dear learner, please convince yourself this is correct based on the above concept).

c) At low levels of income dis-saving occurs (saving is negative)

As can be understood from the above discussions, during low income period, an individual has to
either borrow or withdraw some of his/her earlier savings to cover his/her consumption
expenditure. This is termed as dissaving and represented by negative saving (See Table 3.1).
When the level of income increases and becomes enough to cover all consumption requirements
the person stops borrowing and/withdrawal and eventually begin to save.

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4.1.4. Derivation of the saving function

In a two sector economy consisting of household and business sector, income is either spent or
saved. Given this, one can explain the behaviour of saving if one knows about consumption. In
the derivation, we also take the case where there is efficient transfer of savings to investment
through borrowers by banks. Under this case, the level of saving is equal to the level of
investment; i.e. I = S.

And S = I

So we can write the aggregate demand or income as

Once we have derived saving function and here one can note that when income is zero i.e. Y = 0
then S = -a which means that people’s saving is negative. This indicates that in order to consume
people should either use their past savings or borrow (use their future savings).

In addition, marginal propensity to save is equal to (1 – c) or (1 – MPC). If MPC = is equal

to 0.75, then MPS is equal to = (1 - 0.75 = 0.25). This proves an important relationship

between MPC and MPS in the economy. Since the entire income or all disposable income is
either consumed or saved (Y = C + S), if some part of income is consumed then the remaining
part will be saved. This implies that the sum of MPC and MPS equals one (MPC + MPS = 1).
This can be represented using a graph given below (Figure 4-2).

Figure 4.2: Relationship between Consumption and saving function

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 Consumption (C)
C a  cY

Income (Y)

Saving (S)
S  a  (1  c)Y

Income (Y)
-a

This figure clearly put that both the consumption and saving functions are positively sloped
because both increase as income increases even if the rates may be different. The figure also
shows that the consumption function has positive intercept. The existence of positive intercept
means that for a person to survive there must be positive consumption even if his /her income is
zero. However, the saving function has negative intercept implying that a person has borrowed or
withdrawn its earlier savings for the purpose of consumption during the period of zero income.

Example:

Given consumption function of a two sector economy as find

a) Saving function

b) MPC

c) MPS

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 d) Compare the values of MPC and MPS

Solution

a) Y=C+S

S = Y – C but

S = Y – (40 + 0.7Y)

S = Y – 40 – 0.7Y

S = – 40 + Y – 0.7Y

S = – 40 + 0.3Y

b) MPC = dC/dY = 0.70 (it is simply equal to the slope of the consumption function)

c) MPS = dS/dY = 0.3 (MPS is also equal to the slope of the saving function)

d) MPC + MPS = 0.7 + 0.3 = 1 (this implies that MPC = 1 – MPS and MPS = 1 – MPC)

We hope that you are getting the ideas discussed above. In order to understand better let us
quickly complete this activity.

Activity 3.1.

a) In your personal life do you think income and consumptions are related? Justify you
view?

b) List the variables that affect your consumption and compare them with that of your
partner.

c) Do you find any change in consumption if you move from short run to long run (i.e.
do you think that the relation of your daily consumption to income is different from
that of your annual consumption or more than a year consumption? Elaborate on
your answers.

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 d) When you had no income, you were eating and purchasing cloths among other things.
What do you call such level of consumption expenditure? How did you pay for it?
Discuss your answer(s) with your partner.

e) Try to list down your level of consumption and income over last five months and then
calculate the values of your marginal propensity to consume (MPC) and average
propensity to consume (APC). Compare your answer with that of your partner.

Dear learner, have you completed the above activities? Very good! Now let us understand some
more concepts related to consumption and the consumption function.

4.1.5. Keynesian Consumption Puzzle

Early Keynesians were enthusiastic about Keynes’s innovation for two reasons. The first reason
is that if there is a stable relationship between consumption and income, then the amount of
investment, government spending and taxes necessary to achieve the full employment can be
determined. Secondly, the early empirical studies based on cross-section data appeared to
confirm the relationship. However, after World War II, several economists cast doubt on the
usefulness and validity of Keynes consumption function. The reason for this is that the
Keynesian consumption function was unable to predict the post war values. The estimations
made by Keynes were much less than the actual amounts. During this time Simon Kuznets
published data for the United States between 1869 and 1938 which appeared to be linear, but the
line started from the origin. This can be put in equation form as . In other words, ‘a’ was
approximately zero. And the value of ‘c’ is more than the previous Keynesian estimates.

During the war national or government expenditures increase implying increased income through
multiplier effect. This in turn leads to reduced average propensity to consume (APC) implying
depressed Consumption. During the war, things become expensive resulting in reduced
aggregate demand (AD). In principle, aggregate demand (AD) stays in stagnation unless
government uses corrective fiscal policy. For instance, the government reduces tax and increases
subsidy to increase demand. However, the stagnation in aggregate demand is not observed in

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reality. The failure of secular stagnation and Kuznets’s finding proved that average propensity to
consume (APC) is stable as opposed to Keynes’ conclusion.

Dear learner, what is the puzzle therefore? The answer is straight forward. What is referred to as
Keynesian consumption puzzle is the lack of clear idea or agreement whether the value of
average propensity to consume (APC) is constant or declining as a result of the failure of
Keynesians to identify that the consumption function has different behaviours in different time
frames. This puzzle occurred when the real world evidences happen to confirm and contradict
the Keynesian absolute income hypothesis. If the Keynesian absolute income hypothesis is valid
as confirmed by the earliest empirical studies based on cross sectional data, this implies that APC
is falling with income and the secular stagnation should have occurred when war time
expenditures cease and aggregate demand stagnates. The Kuznets’s finding, which proved APC
to be stable, is compatible with the failure of the secular stagnation but it is contradictory with
the earliest cross sectional studies and Keynes theory. So, the problem (which is called the
Keynesian consumption puzzle) was which of these two contradictory ideas we should
acknowledge.

Figure 4.3: The Short-run and Long-run Consumption Function

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 Consumption
(C) C cY
C a  cY

450

Income (Y)

Initially, these ideas were presumed to be conflicting or negating each other. But, later these
ideas were reconciled when it was found that both findings were correct in different time frames
(one in the short run and the other in the long run). Due to this, on the empirical evidence, there
appear to be two consumption functions: short run and long run consumption functions. This can
be shown in the graph shown above (Figure 4.3).

One interesting feature of these findings is that in both the cases marginal propensity to consume
(MPC) is constant. In the case of the short-run consumption function, the average propensity to
consume decreases as income increases (we have seen this in table 3-1) representing Keynesian
position whereas in the case of the long-run consumption function, the average propensity to
consume (APC) is constant representing Kuznets’s position.

There is a final reconciling conclusion of the opposing results of Kuznets and Keynes.

1. In the short run, the average propensity to consume (APC) falls as income rises. This is
because in the short run consumption does not immediately rise as fast as income.

2. In the long run, the average propensity to consume (APC) is stable or remains constant
because people tend to spend their money on durables as income increases. Thus,
Keynes’ theory is valid in the short run, but not in the long run.

Exercise 3.1

a) Define the following concepts:

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 i. Marginal propensity to consume (MPC)

ii. Marginal propensity to save (MPS)

iii. Average propensity to consume (APC)

iv. Autonomous consumption

v. Dis-saving

vi. Consumption puzzle

b) Explain why marginal propensity is positive but less than one?

c) Why Keynes’ theory is valid in short-run, but not in long run?

d) How the Kuznets and the Keynesian consumption theories can be reconciled?

e) Explain the relationship between: i) MPC and APC ii) MPC and MPS iii) Level of
income and saving.

f) Given the following information on consumption and income, fill the missing values.

Disposable Income (Yd) Consumption (C) APC MPC Saving MPS

150 200

200 240

250 280

300 320

350 360

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 400 400

450 440

500 480

g) Interpret the results you obtained in question ‘f’ and draw some relations among those
values (MPC, MPS and APC).

h) Given consumption function C = 24 + 0.8Y, in a two sector economy, derive the saving
function. What do you understand from the intercept value of the saving function?

i) In two sector economy, what type of relationship do you think exist between the slope of
consumption function and the slope of the saving function? (Hint: the relation may be
expressed in terms of the sum of the two slopes)

j) Given consumption function C = 33 + 0.82Y in two sector economy,

i. What is the level of autonomous consumption

ii. Calculate the value of marginal propensity to consume (MPC)

iii. Find the value of average propensity to consume (APC) and

iv. What do you conclude from your results in ‘i’ and ‘ii’ above?

Did you find difficulties in solving the above exercises? To successfully deal with the questions
in this section, please go back and re-read thoroughly the discussions made.

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Self-Assessment Test-3.1

Dear learner, please make tick mark (√) in front of the activities that you can perform/
understand to do. I can:

1) Define consumption expenditure ---------------------------------------------------------□

2) Differentiate among APC, MPC and MPS----------------------------------------------□

3) Distinguish between Keynesian and Kuznets’s consumption function -------------□

4) Calculate MPC, MPS, and APC given consumption function/schedule------------□

5) Derive saving function given consumption function -----------------------------------□

6) Explain what consumption puzzle is and how it is solved ----------------------------□

! If more than one of your responses to above questions are ‘Negative or not ticked”,
please read the above lesson again and discuss with colleague(s).

4.5 Theories of Consumption

We have already discussed about the most popular consumption and income relationship in the
previous section. However, a number of hypotheses have been developed to explain the short-run
and long-run consumption and income relationship. This section will be addressing some of the
different theories explaining this relationship which include:

a) Keynesian absolute income hypothesis,

b) Relative Income hypothesis,

c) Fisher’s Intertemporal Model of Consumption,

d) Modigliani’s Life-Cycle Hypothesis and

e) Friedman’s Permanent Income hypothesis.

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4.5.1 Keynesian Absolute Income Hypothesis

Dear learner, the consumption function discussed in the preceding section is based on the
Keynesian Absolute Income Hypothesis named after J.M. Keynes who postulated that
consumption is a function of absolute level of income [C= f(Y)]. According to Keynes, the
consumption function can be stated as; C = a + cY where c is the MPC (which is the percentage
change in consumption due to change in income). In this model, income is the most important
explanatory variable of consumption; but interest rate is irrelevant in explaining consumption.
Some economists argued that interest rate determines consumption level. When interest rate in
the banks increases, people save more money in banks to receive the higher interest income and
consume less. However, Keynes had not considered this effect.

The ratio of consumer expenditure to income {(C/Y) = APC} varies inversely with the level of
income both cyclically (from time to time for a given family) and cross – sectionally or across
families (from one family to another during the same period). For Keynesians the long-run
consumption function is stated by the view that short-run consumption function shifts, say
upward, over time and long run consumption function is estimated from shifting points of the
short-run consumption functions. An upward shift in short-run consumption function could be
due to many reasons. Some of these reasons are:

i. Migration from rural to urban areas. This forces the people to spend more even if income
has not increased as urban people spend more than the rural people.

ii. Introduction of new products. This can shift the consumption function up ward as it
stimulates consumption.

iii. Population increase which will add to a country’s consumption and shifts its function
upward.

iv. Economic progress increases individual’s income which in turn increases consumption
level.

Thus, the proponents of absolute income hypothesis argue that the short-run consumption
function shifts upward and produces the long-run consumption function as shown in Figure 4.4.

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 Figure 4.4: The Short-run and Long-run Consumption functions

LRC = cY

SRC3 = A3 + c3Y
Consumption (C)

SRC2 = A2 + c2Y
A3

A2 SRC1 = A3 + c3Y

A1

Income (Y)

Where SRC1, SRC2, and SRC3, are shifting short run consumption functions;

LRC is long run consumption function; and

A1, A2 and A3 are the levels of autonomous consumption levels corresponding to SRC1,
SRC2, and SRC3 respectively.

4.5.2 Relative Income Hypothesis:

Under relative income hypothesis, consumption is a function of current income relative to the
highest level of income previously attained. James. S. Duesenberry explained that there is a
strong tendency in our societies for the people to emulate their neighbours and to strive towards a
higher standard of living. If income falls from Y 1 to Y2, then people move in their short run
consumption function as shown in the Figure 4.5 and reduce their consumption to C 1. This is due
to the fact that people try to maintain their previous standard of living. When their income
increases, then people will increase consumption in the short run till the previous peak is
reached. Then, they move on long run path to achieve the higher peak.

Figure 4.4: Relative income hypothesis and consumption function

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 C = cY

SRC1
C
SRC2

C1

C2

Y
Y2 Y1

Based on this, James S. Duesenberry explained an interesting concept called demonstration

effect. A family with any given level of income will typically spend more on consumption if it
lives in a community in which income is relatively low than if it lives in a community in which
income is relatively high. For instance, if a household with monthly income of 500 living in a
community with monthly incomes of 450, 560, 600, 900 and 980 spends 300 per month, it would
spend more than 300 if it lives in community with monthly income of 870, 950, 1500, 1800 and
2300. In short, this theory holds that there is psychological and family member pressure on a
person or household living in high income community to spend more on consumption.

According to this theory (as it can be seen from the above figure), when income of a household
declines from Y1 to Y2, the household will not consume C2 level; rather, it will consume a higher
level C1 by moving to on the short run consumption function. This is because the decline in
income makes it a relatively low income household in the community and so spends relatively
more on consumption. Normally, when a family lives in a locality with higher income groups
then the family with lower income spends more by seeing the spending pattern of other families
in the same locality. This tendency arises from pressure on the family to ‘keep up with the
joneses’ or from the fact that the family observes the goods and services used by the neighbours
and try to purchase those goods which are superior goods due to demonstration effect. For
example, in a locality if somebody buys a colour television then immediately one can see other

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families also buying the same irrespective of their income. This is called demonstration effect
where they try to demonstrate by purchasing superior goods and services.

4.5.3 Fisher’s Intertemporal Model of Consumption

In this model, one can understand from the term ‘intertemporal’ that it is concerned with
consumption plan over time. This model is the basic framework for modern optimization
analysis of consumer behaviour. The model begin its analysis with utility function, given as Ut =
lnCt subject to a given income constraint (Y). The term ‘lnCt’ is the natural logarithm value of
consumption level.

This function fulfils the usual properties of marginal utility function:

a) positive marginal utility (MU) condition given by MU = δUt /δCt = 1/ Ct > 0; and

b) the diminishing marginal utility condition (which means marginal utility function is
negatively sloped over the valid or feasible range) given by:

ΔMUt/δCt = δ2Ut/δCt2 = δ (1/ Ct) /δCt = -1/ Ct 2 < 0.

The major assumption underlying this model is that there is no bequest transferred from ones’
life time income to the next generation such as daughter(s) or son(s). The model further assumes
that expected life of a person is T years. This shows that the model is concerned about
calculating current consumption which maximizes expected utility over the current and future
periods given the intertemporal budget constraint given by the following identity.

Where ‘Ct’ is consumption level at time t,

‘Yt’ is the level of income at time t,

‘r’ is the market interest rate and

‘T’ is expected life of the person.

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This identity represents discounting which is the way of calculating the present value(s) of future
costs and income given as follows:

= ………………..+

= ………………...+

The utility function to be maximized is given by the natural logarithm of the consumption level
as follows:

Ut = lnCt

But, the utility function is should also be discounted as:

Ut = , where ‘σ’ is the individual’s subjective discounting rate.

In general, the model tries to analyze the consumption pattern which maximizes this utility
function:

T
ln Ct
 1    t
Ut = t 0
= + + …………..+

Subject to the intertemporal budget constraint given by:

T T
Ct Yt

t 0 1  r 
t =  1  r 
t 0
t

One method of maximization is through formation of the Lagrange Multiplier (L) given by the
following equation:


T T
T
ln Ct Yt Ct
Maximize: L = 
t 0 1   t + 
t 0 1  r 
t -  1  r 
t 0
t

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Where, is a positive constant that measure the marginal utility of an additional unit of wealth or
money.

Expanding the summation expression for time t = 1, 2…. .T, we obtain:

ln C1 T
Yt T
Ct
L = lnC0 +
1   1 +………. + +  1  r 
t 0
t -  1  r 
t 0
t

As shown below, utility is maximized at the point where the first order derivative of the
Lagrange multiplier function with respect to each period consumption level is zero; given below.

=0 …………………………………………... (1)

……………...... (2)

By multiplying both sides of equation (2) by , we can obtain;

1  r t  1  
…………………………………………..….. (3)
1   t  Ct 

By substituting equation (1) in equation (3) and by multiplying both sides by ‘Ct’, we obtain the
following.

= = = ……………………….………… ……… (4)

Note the relationship between consumption in time t and time 0 and the power of the term on the
right hand side of equation (4). From this, we can generalize that consumption level of any two
adjacent periods are related by the following relation.

= = Ct = Ct-1………………..…….. (5)

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From the identity given by equation (5), we can identify three major consumption patterns or
consumption time paths depending on the values of return from saving given by ‘r’ and the
return from consumption measured by subjective discount rate ‘σ’. These are:

i. Increasing consumption time path: If rate of interest is greater than discount rate (r >
σ), then current consumption will be greater than previous period’s consumption (Ct > Ct-1,).
In other word, it is better for consumers to save now and consume more in the future. This
situation implies upward sloping consumption curve.

ii. Declining consumption time path: If rate of interest is less than discount rate (r < σ),
then current consumption will be less than previous period’s consumption (Ct < Ct-1).
Hence, it is better for consumers to consume more presently than saving implying a
downward sloping consumption curve.

iii. Constant consumption time path: If rate of interest is equal to discount rate (r = σ),
then current consumption will be equal to previous period’s consumption (Ct = Ct-1). Thus,
consumer(s) will be indifferent between consuming and saving, implying horizontal
consumption curve.

Figure 4. 6: Consumption Time Path

Consumption r>σ
(C)

r=σ

r<σ

Time

Figure 4-6 shows all the three conditions discussed above. For instance, if r > σ, which means
that banks interest rates are greater than subjective discount rate, current interest income will be

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attractive. This means, people will save more currently and consume more in the future. This is
represented by upward sloping consumption time path. Similarly, r < σ means that current banks
interest rates are very low and are not much attractive. This, people consume more currently
instead of saving. This is represented by declining consumption time path. Finally, following the
same argument, r = σ is represented by a constant or horizontal consumption time path.

4.5.4 Modigliani Life Cycle Hypothesis (Ando - Modigliani Approach)

It was discussed in the previous section that there was a conflict between Keynes theory and
earlier findings on one side, and the secular stagnation hypothesis and Kuznet’s findings on the
other side. For Keynes, the average propensity to consume (APC) is a declining function of
income whereas for Kuznets, the average propensity to consume (APC) remains constant as
income increases.

During the dawn of 1950s, F. Modigliani, Ando Albert and Richards Brumberg explained the
declining APC function based on Fisher’s consumption model. They classified the society into
different age groups. The main argument is that income varies systematically over these age
groups. To convert these systematically varying incomes into more or less linear consumption,
consumers use saving and borrowing; and these situations enable consumers to move income
from those times in life when income is high to those times when income is low. Thus, according
to this assumption, a typical individual has an income stream that is relatively low at the
beginning (very young age) and at the end of her/his life (during old age). The individual might
be expected to maintain more or less constant or perhaps slightly increasing level of
consumption. (See the figure below).

Figure 4.7: Life Cycle Consumption Hypothesis

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Consumption (C) Consumption
Income (Y) Saving

Dissaving

Income
Borrowing

Time

This consumption path corresponds to the case where market interest rate is greater than
subjective discount rate (r >) in Fisher’s model. Modigliani considered time preference in
consumption by mentioning current preference is better than delayed preference. Thus, the
consumption curve is upward sloping.

The Fischer’s model classified ages of individuals into three paths of age (young, middle, and
old age) and so called life cycle hypothesis. According to the model, an individual is a net
borrower in earlier years of his/her life and saves during the middle age to repay young age loans
and to provide for old age consumption. In the model, consumption is linear while income is
nonlinear over time. This is because individuals have no income or have very low income during
their young age, for instance, when they are in schools for training. However, once they
complete their education or training and get employed they will get relatively larger income.
During old age again people usually need recreation which means the person has to work lower
hours and as a result receive lower income; or they may eventually retire from their job. This
situation implies that they may get very low income.

This hypothesis tries to give justification for the two conflicting results about the trend of APC
(consumption puzzle). Modigliani concluded that the Keynes’ and Kuznets’s results are not
conflicting. However, both findings are valid in different time frames. Thus, the life cycle
hypothesis supports the Keynes’s idea that average propensity to consume (APC) is a declining
function of income and the marginal propensity to consume (MPC) is less than the average

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propensity to consume (APC) in the short run, while it supports the Kuznets’s idea that the
average propensity to consume (APC) is constant in the long run.

The former relationship can easily be seen from the fact that marginal propensity to consume
(MPC) is the slope of the total consumption curve while the average propensity to consume
(APC) is measured by the slope of a line from the origin to a point on the consumption curve.
The fact that there is some consumption even at zero level of income implies a positive intercept
and the marginal propensity to consume (MPC) becomes less than the average propensity to
consume (APC).

According to life cycle hypothesis, cross sectional data shows that high-income groups are the
middle age group. During middle age there is higher savings relative to consumption which
simply means that there is lower average propensity to consume (APC). Furthermore, the
hypothesis explicitly added wealth as explanatory variable of consumption trend.

Activity 3.2

a) Are you convinced with the logic used in life cycle hypothesis? Why? How? Discuss
with your partner.

b) If you get transitory income, would you eventually increase your transitory consumption?
Why? What consumption theory justifies your answer? Discuss with your partner.

c) Which of the consumption theories convinces you more? Discuss with your partners.

d) Try to write down estimated consumption and income level of a person at his/her three
different ages (by age of teens, 30s to 40s and then that of 70s and 80s). Compare the
consumption and income level over these three different age ranges. What do you
conclude from the comparison you made? Which consumption theory helped you to
answer the questions?

e) Discuss with your partners about

i. Consumption puzzle

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 ii. Demonstration effect

iii. Relationship between age and saving in Modigliani life cycle hypothesis.

Dear learner, have you completed the above activities? Very good! Now let us now proceed to
the next topic.

4.5.5 Permanent Income Hypothesis (Friedman Approach)

According to permanent income hypothesis, income does not have a predictive trend. According
to the proponents of this theory, people rather experience random and temporary changes in their
income from time to time. In earlier theories, consumption is taken as a function of current
income, which can be given as follows:

C = f (Y)

On the other hand, for Friedman consumption is not a function of current income but a function
of permanent income. Income has two components:

a) permanent income (Yp) and

b) Transitory income (YT).

We can also identify the corresponding permanent consumption and transitory consumption.
Permanent income is the amount of income that a person receives in constant collection base and
with knowledge of the amount of income to be collected in the nearer future. Transitory income
on the other hand is unanticipated income; it may be positive or negative. For example, a farmer
may receive more income than anticipated if the weather condition is favourable. Similarly, a
person can earn less due to illness or natural disasters. If a household’s transitory income is
positive, then its actual income exceeds its permanent income.

Similarly, a household’s actual consumption may also be divided into permanent and transitory
components. Permanent consumption (Cp) is determined by permanent income. Transitory
consumption (CT) is unanticipated such as unexpected medical bill. Permanent consumption is
the amount that a household can consume while keeping his wealth intact. It is based on the

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household’s anticipated future income. Transitory or temporary consumption on the other hand
refers to unplanned, unanticipated and suddenly emerging consumption expenditure. You should
note that such consumption expenditure does not often exist or it exists in a very rare case.

These categories of income and consumption can be expressed mathematically as follows:

Y = Yp + YT and

C = C p + CT

In the explanation of these relations in this consumption theory, there are three major
assumptions used by the economists who developed the theory. These are:

1. Permanent and transitory incomes are uncorrelated meaning there is no systematic or

functional relationship between the two variables.

2. There is no systematic relationship between permanent and transitory consumptions.

3. There is no systematic relationship between transitory income and transitory consumption.

These assumptions are based on the view that a sudden increase in income (a rise in transitory
income) will not immediately contribute to an individual’s consumption. For instance, if a person
receives unexpected income of 2000 Birr today, that will not be spent immediately. The second
assumption is that when we classify population by income levels, for each income class the
transitory variations in consumption will cancel out so that the average transitory consumption is
zero ( = 0). This means that for some people the value of the transitory consumption will be
negative where as it will be positive for some others and the sum and the average will turn zero.

The validity of these assumptions and that of the model itself depend on the level of permanent
income, especially when we compare with other consumption theories. For instance, the
Keynesian model is more relevant for less developed countries (LDCs) like Ethiopia. This is
because, under depressed consumption level (very low permanent income), there is no much
saving and any rise in income goes to consumption. In this case, consumption is a function of
current income rather than permanent income. Note also that, in general, higher income affects
consumption positively. The existence of loan also affects the validity of the permanent income

93
hypothesis. If there is constraint on borrowing, consumption depends only on current income. In
this case transfer of income from one period to another through saving and borrowing would be
very difficult. In earlier models, we have seen that higher real interest rate reduces current
consumption and increases future consumption.

In Friedman’s permanent income hypothesis, one should not confuse consumption with
consumption expenditure.

a) Consumption includes expenditure on non-durables and only consumed part and/or

depreciated part of durable goods and

b) Consumption expenditure represents current expenditure on both durable and non-

durable goods including part of which may be consumed in the future.

The focus of these hypotheses is on consumption (not consumption expenditure).

Example:

Suppose a person has the following consumption related experience currently (this year):

 Purchased 1,000 Birr value car tyre this year whose estimated value of 300 Birr will be
used or will depreciate this year

 Consumed or used this year half of fuel purchased last year with 800 Birr last year (if
fuel price is the same as that of last year).

 Spend 12,000 Birr for food and recreation in the current year

 Paid 600 Birr for current year telephone and electric bill.

 Rented residential house at 3,000 Birr per year and paid 9,000 Birr for the next three
years including current year

Then, determine the current year:

a) Consumption level of the person and

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 b) Consumption expenditure level of the person

Solution:

a) Consumption = sum of expenditure on non-durables and only consumed part and/or

depreciated part of durable goods

= 300 + 0.5 (800) + 12,000 + 600 + 3000

= 16300 Birr

b) Consumption expenditure = sum of all current expenditure on both durable and non-
durable goods including part of which may be consumed in the future

= 1,000 + 12,000 + 600 + 9,000

= 22,600 Birr

Functional and Graphical presentation of Permanent income hypothesis

Consumption is a function of permanent income: C = f (Yp), assuming linear relationship the

consumption function will take the form, C = Yp where ‘’ is a constant. The extra transitory
income (YT) above the trend of permanent income (Y P) goes to savings or purchase of durables
for future consumption i.e. people usually save the transitory income rather than to consume.
Thus, transitory income does not explain consumption.

Figure 4-8: Permanent income and transitory income

YT, YP
YP
YT

Time

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 APC = =

From this identity, it is clear that the value of average propensity to consume (APC) is somewhat
stable if there is change only in the permanent component of income (YP). However, if there is an
increase in the transitory component of income (YT) (which is a short run phenomenon) the
average propensity to consume (APC) tends to decline. Thus, a fall in average propensity to
consume (APC) is a short run phenomenon because transitory income is not something that
sustain in the long run. Friedman, along with A. Modigliani, assumes that consumers want to
smooth their actual income stream into a more or less flat consumption pattern. This gives a level
of permanent consumption that is proportional to permanent income. The individual ratio of
permanent consumption to permanent income presumably depends on: the interest rate (return on
saving), individual tastes (shapes of indifference curves), and variability of expected income.

Friedman’s model is less satisfactory when compared to Modigliani’s model in that it takes into
account that assets are only implicitly taken into account as a determinant of permanent income.
In addition it relies on less observable aspects of income (permanent and transitory income) than
the Modigliani’s model, which identifies the observable components labour income and value of
assets. Nevertheless, the two models are closely related. Families with high transitory income in
Friedman’s analysis could be families in the middle age years in Modigliani’s life cycle model;
and families with negative transitory income could be one at the young age or at the old age of
their life cycle. Thus, the life cycle hypothesis could be one explanation of the distribution of
Friedman’s transitory incomes. The Modigliani model might also be more useful for econometric
model builders and forecasters since it explicitly includes measured current income and assets to
explain consumption. However, it may need careful interpretation in cases where income
changes are clearly temporary and permanent income considerations are more relevant.

Now it is time to complete the following exercise. Good luck! If you face any difficulties then
please read the section once again.

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Exercise: 3.2

1. Relative income hypothesis takes into account the relative income into consideration.
Explain how consumption changes in short run and long run.

2. Explain demonstration effect? Do you think it is applicable in Ethiopia? Why? How?

3. Explain the concept of permanent income and transitory income.

4. Explain how the permanent income hypothesis and life cycle hypothesis explain mutual
acceptance of both concepts of declining and constant APC. Elaborate with examples.

5. List out the three major consumption paths in Fisher’s consumption theory.

6. What are the factors that determine the consumption paths mentioned in question 5.

7. In Modigliani life cycle hypothesis, there are three activities used to smooth consumption
from non smooth income. List them out.

8. List the three assumptions held about relationship among different categories of
consumption and income in permanent income hypothesis.

Self-Assessment Test: 3.2

Dear learner, please put a tick mark (√) or (x) in front of the activities to confirm whether
you can or cannot perform/understand the listed activities. I can:

1) Define Keynesian consumption function ----------------------------------------------------□

2) Explain short run and long run relationship between consumption and income-----□

3) Define and discuss demonstration effect and relative income hypothesis -------------□

4) Define Inter-temporal consumption ----------------------------------------------------------□

5) Explain the different consumption theories --------------------------------------------------□

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6) Identify the relevant consumption theory for Ethiopia or LDCs -------------------------□

7) Explain the relationship between age and income pattern -------------------------------- □

8) Differentiate between transitory income and permanent income -------------------------□

! If more than one of your responses to above questions is ‘Negative or not \ ticked”,
please go back and re-read the above lesson and discuss with partner.

Self-Test Exercises -3

1. At a level of income of Birr.20, 000 and the consumption level is also Birr.20, 000. If the
MPC is 0.7. The autonomous consumption amount should be

a. Rs.4,900

b. Rs.5,000

c. Rs.6,000

d. Rs.7,000

e. Rs.14,000

2. The equation C = 20 + 0.90 Yd predicts that consumption is

a. 90 when disposable income is 100

b. 100 when disposable income is 90

c. 110 when disposable income is 100

d. 180 when disposable income is 200

e. 110 when disposable income is 100

3. In short run the consumption income relationship is

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 a. Linear starting from the origin

b. Linear with a positive intercept

c. Right angle

d. There is no relationship

e. Rectangle hyperbola

4. In long run the consumption and income relationship is

a. Linear starting from the origin

b. Linear with a positive intercept

c. Right angle

d. There is no relationship

e. Rectangle hyperbola

Given the following current (this year) consumption related experience:

 Purchased 2,000 Birr value car tyre this year whose estimated value of 500 Birr
will be used or will depreciate this year

 Half of the cleaning machine purchased at the beginning of the current year with
1,000 Birr has been depreciated.

 Spend 8,000 Birr for food and recreation in the current year

 Paid 800 Birr for current year telephone and electric bills.

 Rented residential house at 2,000 Birr per year and paid 8,000 Birr for the next
four years including current year.

Then answer the following questions (5 and 6)

99
5. What is the current year consumption level of the person?

a. Birr. 10,100

b. Birr.11,800

c. Birr. 19,800

d. Birr. 12,500

e. Birr. 8,500

f. None of the above

6. What is the current year consumption expenditure of the person?

a. Birr. 10,100

b. Birr.11,800

c. Birr. 19,800

d. Birr. 12,500

e. Birr. 8,500

f. None of the above

7. Which of the following pairs of income pattern and income related and consumption
activities are paired incorrectly?

a. young age low income – borrowing

b. middle age high income – dis-saving

c. old age low income – dis-saving

d. old age high income – dis-saving

100
 e. b and d are the answers

f. a and c are the answers

8. Which of the following consumption theories explains the fact that a person will consume
more if he is living in the community of high income than if he lives in a community of low
income?

a. Demonstration effect theory

b. Life cycle hypothesis

c. Permanent income hypothesis

d. intertemporal theory of consumption

e. All of the above

f. None of the above

9. Which of the following statements is necessarily true?

a. average propensity to consume remains constant in both short run and long run

b. average propensity to consume is a declining function of income

c. marginal propensity to consume is uniform among groups of people with different level
of income

d. the value of marginal propensity to consume is always between zero and one

e. a and c are answers

f. All of the above

g. None of the above

101
 Unit Summary

In this unit, we started with very simple consumption and income relationship in short run which
Keynes suggested as linear type. A linear consumption has some property which can be
summarized in Keynesian psychological consumption function and which asserts that marginal
propensity to consume is always more than zero, but less than one. Moreover, Keynes concluded
that average propensity to consume is a declining function of income; i.e. its value declines as
income increases.

This idea was criticized by Kuznets who found out that the relationship is not linear, rather it is
quadratic. Moreover, using long run data, Kuznets found out that the value of average propensity
to consume (APC) is constant over time (as income increases). This indicates that there are two
consumption function i.e. short-run and long-run consumption function. Later, many other
theories have developed to support this relationship. Some of these theories later reconciled the
seemingly conflicting ideas of Keynes and of Kuznets about the value of average propensity to
consume (APC). They proved that declining APC according to Keynes is true in the short run
and Kuznets’s constant APC as income increase is true in the long run.

Relative income focuses on peculiar behaviour of human beings to demonstrate by seeing the
spending pattern of neighbours. The person will consume more simply because he observes
people consuming more. Permanent income hypothesis stresses more on the components of
income and consumption and categorizes consumption and income into permanent and
transitory. Permanent income finally determines the level of permanent consumption. This
theory emphasizes that a person will not quickly spend all income that has obtained
unexpectedly (or in temporary base).

Inter-temporal consumption, on the other hand, focuses on consumption plan over time.
According to this theory, depending on relative values of banks interest rate and subjective
discount rate there are three different consumption time paths: increasing consumption time
path (if banks interest rate is greater than subjective discount rate), constant consumption time

102
 path (if the two values are equal) and declining consumption time path (if banks interest rate is
lower than subjective discount rate).

Similarly, life-cycle hypothesis takes the whole life as one cycle and tries to explain different
consumption in different stages. The life-cycle has three stages: young age with low income,
middle age with high income and old age with low income. Over this fluctuating income
period’s, people are expected to have more or less constant (uniform) or slightly increasing
consumption over time. The fluctuating income is transformed to non fluctuating consumption
path through borrowing, saving and dis-saving (withdrawing).

Suggested References

Branson W. (1989), Macroeconomic Theory and Practice, Third edition, New York Harper and
Row Publishers

Edward Shapiro; Microeconomic Analysis (2000), 5th Edition, Harcourt Brace Jovanovich, Inc,
New York.

Gardner Ackley; Macroeconomics. Theory and Policy, 1987, McMillan.

Gregory Mankiw; (2000), Macroeconomics. Worth publishing.

R. Dornbusch and S. Fisher; Macroeconomics (1994) 2nd Edition, or any other edition, New
York, McGraw-Hill International Edition.

Answer for self-tests

Unit-1
Answer Key for self-test 1
1. D
2. A
3. C
4. B
5. D
Unit-2
Answer Key for self-test 2

103
1. A
2. E
3. D
4. F
5. B
6. B
7. F
8. E D C A B
Unit-3
Answer Key for self-test 3
1. A
2. A
3. C
4. D
5. D
6. A
7. A
Unit-4
Answer Key for self-test 4
1) C 2) C 3) B 4) A 5) B
6) C 7) E 8) A 9) D

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