APPROACHES OF MACRO ECONOMICS and MODELS OF CIRCULAR FLOW OF INCOME

Objectives: After studying this lesson, you will be able to understand Different economic approaches in an economy Various macro economic variables in an economy The definition of Circular flow of income and expenditure The distinction between money and physical flows The Circular flow of income and expenditure under different sector models The importance of circular flows under different sector models

2.2.1 introduction 2.2.1 Economic Approaches

2.2.2 Macro Economic Variables

2.2.3 Circular flow of Income and Expenditure in Two Sector Model 2.2.4 Circular flow of Income and Expenditure in Three Sector Model 2.2.5 Circular flow of Income and Expenditure in Four Sector Model 2.3 Summary

 2.1 Introduction:
Macroeconomics is the study of economic system as a whole. It covers not individual units but of all the units taken together, thus macroeconomics became the study in aggregates and is often called Aggregative Economics. Mainly it deals with the theory of income, Employment, Prices and money. The Great depression (1929-32) and unemployment are the two main causes that led to the emergence of macroeconomics as an important area. JM Keynes became the chief advocate of macroeconomics he brought out the general theory in 1936. In fact, this book may well be described as Aggregative Economics Many economists had contributed a lot to strengthen the subject, like, L Walrus, K Wick sell and I Fisher in desire to control business cycles and contribute their mite towards the development of macro economic studies.

Boulding says Macro economics, is that part of the subject which deals with aggregates and averages of the system rather than with particular items in it and attempts to define these aggregates in a useful manner and to examine their relationship
Professor

As stated earlier, macro economics deals with several aspects related the whole economy, like how the level of income and employment determined, how the general price level determined, how consumption, Investment and Liquidity preference functions conceived in aggregate terms etc., We have explained in brief all aspects of macro economic theory. These aspects are shown in the following chart.

Macro economic theory | --------------------------------------------------------------------------------Theory of Income & Theory of General Price Level Theory of Economic Growth Employment & Inflation | --------------------------------------Theory of consumption | Function Theory of Investment | | ---------------------------------------------| Theory of Fluctuations (Business Cycles)

An individual may become rich by finding a few currency notes but no country will become rich by printing few more notes. Further, one man by wiillingness to work for less may overcome his own unemployment, but the general unemployment problem cannot be solved in this way. Again, wage cutting in a particular firm may promote employment, but the general wage cutting in the economy as a whole may actually diminish the volume of employment. Thus, what is prudent behaviour for an individual or single business firm may at times be a folly for a nation or a state. Examples could be multiplied. Most of these cases, which seem paradoxical at first, stem from the fact that what is true for an individual, are true only if other things remain equal. It is a legitimate assumption in microeconomic analysis. In macroeconomics, however, such a presumption is not justified; therefore, quite a different approach to the analysis of macroeconomic problems must be developed. Professor Samuelson calls above instances the fallacy of composition and prof. Boulding call them Macroeconomic Paradoxes.

Paradoxes according to Prof Boudling, are those propositions which are true when applied to a single individual but which are untrue when applied to the economic system as a whole. There is little scope for the blind application of conclusions regarding individuals to the economic system as a whole, therefore, great action and care is needed for the application of microeconomic conclusions to the field of macroeconomics. Hence, there is a perfect justification for evolving and developing macroeconomics as a separate branch of economics analysis.
Macroeconomic

Another method of approach consist in the direct study of macroeconomics by passing at the same time the study of individual units and directing the investigations with reference to the economy as whole. This method, too, has its limitations. It studies the economy as a whole while ignoring the individual units, for what holds true of the economy as a whole may not be so in the case of individual units: for example, a study of the aggregates may lead us to conclusion that no change is needed in the general price level, as with a fall in agricultural prices in the economy, other prices may have risen and the two offset each other but in reality steps may have to be taken to stabilize agricultural prices.

Actually, no hard and fast line of demarcation can be drawn between macroeconomic and microeconomic theory. Neither approach by itself is complete without the other. As a matter of fact, no serious student of economic analysis can help studying both the approaches in an unbiased manner. Both micro and macro approaches are needed for complete understanding and solution of economic problems. What particular approach will be best suited for a scientific understand of a given economic situation depends on the object we have in mind. Professor Samuelson rightly says that really no opposition between micro and macroeconomics. Both are absolutely vital. And you are only half educated if understand the one while being ignorant of the other.

2.2.2 Macro economic variables:

Macro economic analysis depends upon a large number of variables or concepts, terms and instruments. Macro economic problems can be easily grasp by understanding these terms and instruments. We explain not all variables but only a few of them, which are more important and prominent in the aggregative analysis. Variables: A magnitude that changes over a given period of time can be called a variable. For instance, different levels of incomes, employment and prices. The variables can be classified as follows: a) Stock & Flow Variables b) Endogenous & Exogenous variables c) Dependent & Independent variables Other terms/devices discussed here are: a) functional relationships b) Time-Series and Cross-Section data c) Ex-ante and Ex-Post d) Identities and Equations e) Equilibrium f) Lag g) Economic Models

Stock & Flow Variables

A stock variable is one, which has no time dimension but is described at a specific moment of time. A flow variable, on the other hand, involves of necessity a time dimension and it is always expressed per unit of time, say a day, a month or a year. For instance a lake fed by a single stream. The volume of water contained in the lake at a given point of times is a stock; the volume of water flowing into it over some period is a flow. In brief, stock variables are measured at a moment f time and have meaning independently of any period. Flow variables are defined necessarily with reference to a period of time and can be measured and given meaning only in terms of this time period.

Endogenous and Exogenous variables:

The variables, which are internal to the economic system and constitute an integral part of the system, are known as endogenous variables. For example, levels of income, output and magnitudes of saving and investment, and demand and supply, etc are essentially the variables which internal to the economic system. But the variables like growth and composition of population, imports, innovations etc may be regarded as the exogenous variables.

Dependent and Independent variables:

A variable is said to be a dependent variable, when its magnitude is related in some unique way with the changes in the magnitude of some other variable. For instance, demand varies inversely with price, if other things remain the same. In this case demand depends upon price of a commodity, therefore, the former is the dependent variabel while the latter is the independent variable. Same can be denoted with: D= F(P), where D= demand, P= Prices, F= functional relation. Demand is dependent variable whereas price is independent variable.
Functional relationships and Parameters: A functional relationship among two or more variables implies that there is some unique relationship between their magnitudes such that change in the magnitude of one variable is associated in some regular and definite way with the change in another variable. The functional relations may be expressed as: C=f (Y); here C consumption, and Q Output are the functions of income (Y). These relationships imply that consumption depends upon income.

Time Series and Cross-Section Analysis: if the data concerning a particular variable are obtained from a specific entity continuously period after period say years, months they constitutes a time series. The cross-sectional analysis is based on the data obtained from the different sub-divisions or cross-sections of the society at the same time. For instance data on Income culled continuously from 1950 to 2005 is known as time-series data, otherwise, it is only in the year of 1950 and 2005 is called as cross section data. Ex-ante and Ex-Post: Ex-ante and ex-post are the Latin terms meaning beforehand and afterwards respectively. The Swedish School of thought prominently introduced the terms in economic literature. Ex-ante variables like savings, investment refers to their estimates at the beginning of a specific period. Thus, in the exante sense, these variables are in the planned, desired. The amount of savings, investment, and income, production in the ex-post sense mean the actual magnitudes of these variables at the end of a specific period. Thus, in the ex-post sense, these variables are actual, realised or observed.

Identities and Equations: A relationship, which is assumed to be true by its definition, is said to be an accounting relationship or an identity. For example, saving may be defined as an excess of income over consumption. Similarly income may be defined as their sum of consumption and investment. Whatever the magnitude of the variables involved, given the above definitional relationships there must be an identity between saving and investment. S = Y-C and Y=C+I therefore: S = I

The behavioural relationships may be expressed in the form of equations and may be denoted by the symbol = . For example;
C = Co + bY Thus the distinction between identities and equations points to the fact that the identities hold whatever the magnitudes of the variables and cannot be tested by empirical investigations. The behaviour relations or equations, on the opposite are the propositions about eh economic behaviours, which can be tested by empirical observations either directly or via predictions derived from them.

Equilibrium: Equilibrium implies such magnitudes of the variables, which do not permit any departure of the economic system from a specific position. In the words of Gardener Ackley: A system can be said to be in equilibrium when all of its significant t variables show no change, and when there are no pressures or forces for change which will produce subsequent change in the values of the significant variables. Lag:

The macro economic problems have been analysed either in terms of instantaneous adjustments or the lagged adjustments. In the study of continuous adjustments, the rates of change of the variables are in such normal or equilibrium relations that the adjustments take place instantaneously and the equilibrium is never disturbed. In the period analysis, the different economic variables pertain to different time period, as the magnitude of one of the variable changes, the equilibrium gets disturbed. Some time interval must elapse before a harmonious adjustment takes place among the different variables, the time interval required for adjustments is called as time lag. For instance, if a change in money supply leads to immediate change in prices is instantaneous adjustment, otherwise is lagged adjustment.

Economic Model: An economic model consists simply of a group or set of economic relationships each one of which involves at least one variable that also appears in at least one other relationships which is part of model. Koopmans considers a model to be a set of structures. In our previous section, we discussed the important macro economic variables and economic approaches at length. The objective of the present chapter is to study the circular flow of income and expenditure in an economy. Circular flow of money means that the money spent must not be hoarded and should continue to flow to maintain a certain level of economic activity. In the process of economic development, various economic activities among the different sectors is takes place, while performing activities, money flows between the different sectors in the form of payments and receipts. These receipts and payments are in both the financial and physical forms. Therefore, in this lesson, our concentration is on, how the income flows among the different sectors of an economy. These flows are discussed under different sectors such as flows between two sectors, three sectors and four sectors. .

2.2.3 Circular

flow of income & expenditure in two-sector model:

In the two-sector model, the circular flow of income & expenditure refers to the process whereby the national income and expenditure of an economy flow in a circular manner continuously between two sectors through time. The important activities are by household sector are sale of its labour for production in the product market to business sector, and purchase of goods and services produced by the business sector in turn, household sector receives the wages as remuneration for rendered its services. On the other hand household sector pay the amount for consuming goods and services to business sector. In this process, both the sale of labour by house hold sector and purchase of goods and services by household sector are became a physical flows and payment of wages to labour by business sector and amount paid for purchases by household sector to business sector, are became money flows. Now let us see there flows which are presented in the fig 2.1 where the business sector which produces goods and services is shown in the upper portion and the household which owns all factors of production in the lower portion. From the business sector, household sector purchases goods and services in the product market and pay the amount, while the household sector, receives income from business sector for the services rendered by the household sector to business sector. Thus, payments go around in a circular manner from business sector to household sector and back as shown by arrow marks in the outer portion of the figure.

Further, the circular flow of income and expenditure with savings and investment gives different information. It means that, in an economy, inflows and outflows occur in the expenditure and income flows. Below figure (2.2) shows how the circular flow of income and expenditure is changed by the inclusion of investment and saving. In this form of system, the household sector provides saving to the capital market. Therefore, the amount supplied in the form of savings by household sector reaches to capital market, in turn capital market invest the savings amount to business sector.

2.2.4

Circular flow of Income and expenditure in three sector model:

Further, the circular flow of income and expenditure with savings and investment gives different information. It means

that, in an economy, inflows and outflows occur in the expenditure and income flows. Below figure (2.2) shows how the circular flow of income and expenditure is changed by the inclusion of investment and saving. In this form of system, the household sector provides saving to the capital market. Therefore, the amount supplied in the form of savings by household sector reaches to capital market, in turn capital market invest the savings amount to business sector.

2.2.4

Circular flow of Income and expenditure in three sector model:

2.2.4

Circular flow of Income and expenditure in three sector model:

If we add the government sector to the two sector closed model, it became three-sector model of circular flow of income and expenditure. Government sector role in an economy is to collect the taxes and purchase of the goods and services. First one is a leakage or outflow from the circular flow and the second one is inflow/injection into the circular flow. The taxes imposed by the government sector are in the form of personal income tax, commodity tax paid by the household sector is considered as a leakage while the purchase of goods and services are injections to circular flow. In addition to purchases, transfer payments, unemployment relief, sickness benefits etc., are all expenditure by the Government al also inflows into the circular flow. Similarly, if we take the transactions between government sector and business sector, business sector pay taxes to government sector, which is leakage from circular flow and government purchases from business sector, subsidies etc., are the inflows into the circular flow. We shown the inflows and outflows in the circular flow by including all three sectors i.e. house hold sector, business sector and government sector together in the fig 2.3

It is clear from the figure that taxes flow out from the household sector and business sector to the government and investment flow out from government to household and business sector. If government purchases exceeds net taxes, then the government finances the deficit by borrowing from the capital market which receives funds from household sector, instead, if government purchases are less than the taxes, it reduces the public debt and supplies funds to the capital market

Circular flow of income and expenditure in a Four-sector model:

So far we have been working on the circular flow of income and expenditure of a three sector closed model. To this we add the foreign sector to make it a four-sector model. Infact, the actual economy in an open economy where foreign trade plays an important role. Foreign trade refers the exports and imports, in which exports to foreign is an inflow and imports for foreign is an outflow from the circular flow. This sort of exports and imports in circular flows are shown in fig 2.4

Now let us see the inflows and outflows of these three sectors in relation to fourth sector. The households purchase the imported goods and service and, it receives the transfer payments from the foreign sector for the services rendered by them in foreign. So first one is leakage and the second one is inflow into the circular flow. On the other hand, the business sector exports the goods and services to foreign and import the goods and services from foreign sector. For which business sector receives and also pay the money. These activities also lead to injections and leakages respectively. Like the business sector, government sector also export and import and lend to and borrow from foreign sector. Similarly, foreign sector also export and import goods and services for which business sector, government sector and household sectors receives payments from foreign sector. Further, government sector also receives royalties, interest, dividends etc., for investment made abroad. All the types of above transactions are shown in fig 2.4

If exports are exceeds the imports, the economy has a surplus in the balance of payments and if imports exceed exports it has deficit in balance of payments. Importance of circular flow of income and expenditure: The Circular flow of income and expenditure highlights the importance of both the fiscal and monetary policies. The importance of monetary policy in circular flow of income and expenditure is observed when savings exceeds investment or investment exceeds savings. It means that the disequilibria in savings and investment set by following credit and monetary policies. Similarly, if savings and taxes amount exceeds the investment and government spending amount should adopt such fiscal measures as reduction in taxes and spending more itself. Therefore, with the help of circular flow of income and expenditure the problem of disequilibria and the restoration of equilibrium can be observed.

2.2

Summary:

Macro economic theory is the theory of Income, Employment, prices and money. Macroeconomics is the study of economic system as a whole. It covers not individual units but of all the units taken together, thus macroeconomics became the study in aggregates and is often called Aggregative Economics. Though there are two different approaches, but no hard and fast line of demarcation can be drawn between macroeconomic and microeconomic theory. Neither approach by itself is complete without the other. The Circular flow of income and expenditure is a simplification of which attempts to illustrate the flow of money and goods from households to business and back to household sector. The circular flow of economic activities is maintained not only in two sectors but also in three sectors and four sectors. The circular flow of income and expenditure explains how the leakages and injections are destabilising the economy. Further, it also recommends the policy and suitable measure to be adopted to restore the equilibrium in the system. We can know whether the economy is working efficiently or whether there is any disturbance in its smooth functioning.

Short

a) b) c) i)

Note Questions: what is macroeconomics? Give a clear exposition of an economic model? Write a note on the following: Stock and flow variables ii) Time series and cross section data

Essay type Questions: a) b) c) d) Distinguish between Micro and Macro approaches? What is the difference between functional relationship and parameters? Explain the Circular flow of income in a two sector system? Discuss the circular flow of income in a four sector system?

Short Note Questions: a) what is macroeconomics? b) Give a clear exposition of an economic model? c) Write a note on the following: i) Stock and flow variables ii) Time series and cross section data Essay type Questions: a) b) c) d) Distinguish between Micro and Macro approaches? What is the difference between functional relationship and parameters? Explain the Circular flow of income in a two sector system? Discuss the circular flow of income in a four sector system?

Suggested Readings Ackley, Gardner: Macroeconomic Theory Shapiro E: Macroeconomic Analysis Paul Samuelson: Economics