Basics of Macroeconomics

Training Course Material for e-Library onSystem of National Accounts

March 2009

Module-I: PP1

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Topics To Be Covered

• Introduction• Circular flow of income and expenditure• Measuring economy• Macroeconomic objectives• Macroeconomic policy

– Monetary policy– Fiscal policy

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Introduction• People have unlimited wants and needs• The wants and needs are satisfied by

consuming goods and services (commodities)

• Commodities are produced by using resources

• Income gets generated to owners of resources who get income (factor) shares in the process of production of goods and services

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Introduction (Contd.)

• The resources are factors of production

Resource Factor Income (Factor) share

Natural Land Rent

Human Labour Salaries/Wages

Financial Capital Interest

Managerial skill Enterprise Profit /Loss

Produced M&E Depreciation

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INPUTS:

RESOURCES /FACTORS OF PRODUCTION 

PRODUCTION PROCESS 

OUTPUT: GOODS AND SERVICES

INTERMEDIATE USE and FINAL USE

 

•DISTRIBUTION 

•CONSUMPTION 

Economic Activities 

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Key Economic Issues • Scarce resources in relation to unlimited wants

and needs• How nations use their scarce resources -

results in future development• Scarcity is the gap between human desires

and available resources.

• Scarcity forces people to make economic choices.

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Opportunity Costs

The Opportunity Cost of using resources for a certain purpose is the benefit given up by not using them in an alternative way

It is what is given up in order to get something else

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Key Economic Problems

• WHAT goods and services to produce?

• HOW to produce those goods and services?

• Labour intensive? Capital intensive?

• WHO should get the goods and services produced?

• Rich? Poor who works hard?

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Two Complementary Ways of Viewing the Economy

• Microeconomics is the behavior in the economy of

– individual markets (eg. for wheat, coal)– individual decision makers (eg. firms, households)

• Macroeconomics is the study of aggregate economic behavior. National, global economies and choices– Total economy output– Unemployment– Productivity– Inflation

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Circular Flow of Income and Expenditure

• The concept of a circularity in economic relations is a critical one.

• It helps to understand how the separate parts of the economy are related to each other in a system of mutual interaction.

• Circular flow of Income and Expenditure is a simplified model for understanding of economic relations.

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The Circular Flow of Income & Expenditure

Producers

Consumers

Factor Markets

Goods Markets

Consumption Expenditure

Sales receipt

Wages, rent, and profit

Income

Goods & Services sold

Goods & Services bought

Labor, land, and capital

Inputs for production

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The Circular Flow of Income & Expenditure (Contd.)

• Two kinds of markets:Goods markets: Goods and services that are

produced by firms are sold in these markets. Factor markets: The services of factors of production

(land, labour, and capital) are sold in these markets

• The interactions involve flows going in two directions:

• Flows in goods and services, called real flows. • Flows of payments for these goods and services,

called money flows

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Govtern-ment

Households

Consumption

Income

Govt. Expenditure

FinancialMarket

Saving

Investment Rest of the World

Imports

Exports

Circular Flow of Income and Expenditure[Showing also Leakages: Saving, Taxes, Imports; and Injections: Investment, Govt. Expenditure, Exports]

Taxes

Firms

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The Circular Flow

1.Three Markets

a) Labor Market

b) Goods Market

c) Financial Market

2.Four Economic Agents

a) Households

b) Firms/Businesses

c) Government

d) Rest of the World

The Circular Flow of Income & Expenditure (Contd.)

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The Circular Flow of Income & Expenditure (Contd.)

• Firms produce goods and services, they create through factor payments the incomes for households

• Households buy consumption goods and services, so there is consumption coming out of Households’ box

• Government collects taxes in order to cover its expenditure

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The Circular Flow of Income & Expenditure (Contd.)

• Households devote part of their income (after tax) to savings, which flows into capital/financial market that in turn makes investment for businesses

• There are several leakages from and injections to the flow around the main circuit

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The Circular Flow of Income & Expenditure (Contd.)Leakages and Injections

• Leakages: [Out from the Households]

– Saving– Taxes– Imports

• Injections: [In to the Firms]

– Investment– Government Expenditure– Exports

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Final Demand of Goods / Services

Y = C + G + I + X- M Where,

C is Household Final Consumption Expenditure

G is Government Final Consumption Expenditure

I is Gross Domestic Investment

X is exports

M is Imports

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Consumption

Consumption is the value of goods and services bought by people

It is a large part of aggregate demand (??)

The economic performance of the country can be judged by the level and dynamics of consumption

Three categories of consumption:

•Spending for consumer durables

•Spending for consumer non-durables

•Spending for consumer services

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Saving• People save, avoiding to consume all their income,

is called “ Personal Saving”• People deposit Saving in bank accounts or in bonds,

shares and other financial instruments (Financial Saving). It can also be invested in acquiring Houses (Physical Assets)

• Consumption is the key determinant (complementary) for the amount of Personal Saving.

• Domestic Saving = Personal Saving + Business Saving + Public/ Government Saving

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• Investment is the net value of machinery, equipment, plants, and buildings/sheds that are acquired by business firms for production purposes.

• All spending by business firms for acquiring new machinery and equipment and business plants/ structures.

• All changes in business inventories of raw materials, semi-finished goods, and finished goods.

• All spending by households for acquiring newly constructed residential housing

Investment

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Government Consumption Expenditure on Goods and Services (G)

(a) Central government

(i) Defense

(ii) Non-defense

(b) State government

(c) Local Bodies

Net Exports (X-M)(a) Exports

(b) Imports

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Measuring the Flow of Income and Expenditure

• There are three possible ways of measuring the flow of income

• Each of the ways looks at a different part of circular flow

• All three should give the same results

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Measuring the Flow of Income and Expenditure (Contd.)

Three approaches of measuring circular flow:

Production Approach: total amount of goods and services produced in one year.

Expenditure Approach : total amount of households final consumption expenditure, government final consumption expenditure, gross investments and net exports in one year.

Income Approach : total incomes earned by the factors of production involved in the production of goods and services in one year.

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Objectives of Government’s

Macroeconomic Policy • Full employment • Keep low inflation• Economic growth • Equitable distribution of income• Low government budget, deficit and

international debt

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Policy Instruments

Fiscal Policies Monetary Policy

Government income

Interest rates

Money in circulation

Government expenditure

How to Achieve These Objectives?

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Fiscal PolicyFiscal Policy

• Fiscal policy: Government spending and Taxation (government income) decisions.

• Government can affect aggregate demand by:– Purchasing more or fewer goods and services.– Increasing or reducing taxes.– Changing the level of income transfer.

• Fiscal policy:– Expansionary– Contractionary

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Fiscal Policy (Contd.)

• Expansionary fiscal policy: • Increase in government spending• Reduction in Taxes

• Contractionary fiscal policy: • Reduction in government spending • Increase in Taxes

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Fiscal Policy (Contd.)

• Tax regime, as a Fiscal measure, influences− Consumption− Investment− Government Spending

• Fiscal Policy also does influence • Education, Health, Poverty Reduction, • Welfare Reforms, Investment, • Regional Imbalances, Promotion of Enterprise,

etc.

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Reduction of Taxes

• The government increases the disposable income of the households by reducing taxes.

• Disposable income is the after-tax income of consumers or personal income less personal taxes.

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Tax Cuts and Investment

• A tax cut may also be an effective mechanism for increasing investment spending.

• Tax cuts have been used to stimulate the economy.

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Transfer Payments

• Increasing transfer payments such as– social security– welfare benefits– unemployment benefits– and veterans’ benefits

Often stimulate the economy

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Monetary PolicyMonetary Policy

• Influences the level of economic activity through – changes of the amount of money in circulation

(Money Supply) – short-term interest rates

• Central bank controls country’s monetary conditions through– Money in circulation– Interest rates

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How do Interest Rates affect Consumption, Saving & Investment

Interest Rates Borrowing

Individuals Firms

Consumption Investment

SavingInterest Rates

Consumption

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How do Interest Rates affect Export and Import Prices

Interest Rates Exchange Rates

Appreciation

Import price down

Depreciation

Import price up

Export price up

Export price down

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