CHAPTER 1

INTRODUCTION TO MACRO ECONOMICS

TO DO:
❖ 1.1 Introduction
❖ 1.2 Distinguish between microeconomics and macroeconomics
❖ 1.3 Importance of macroeconomics
❖ 1.4 Limitations of macroeconomics
❖ 1.5 Examples of macroeconomic variables

1.1 Introduction

The term ‘Macro’ in English has its origin in the Greek term ‘Macros’ which means ‘Large’. In
the context of macroeconomics, ‘large’ means economy as a whole. Macroeconomics is a branch
of economics which veers from studying individual producers and consumers and studies
economy as a whole. The difference between micro and macroeconomics can be explained with
the difference between a tree and a forest. We need forests to influence weather and climate
because a single tree cannot exert a similar type of influence.

Thus, macroeconomics can be defined as that branch of economics which studies economic
activities (including economic issues or economic problems) at the level of economy as a
whole. For example aggregate demand, aggregate supply, national income, general price
level etc.

Define macroeconomics. (AI 2011, Foreign 2012)

Macroeconomics as a branch of economics was born in the 20th century. The great depression of
1929 led to the development of macroeconomics. Earlier there was a school of economists
referred to as the ‘classical economists’. Malthus, Pigou, Ricardo etc. belonged to this group.
Their policy favored Laissez-faire or free economy. Besides they believed that there is always
automatic adjustment in the economy which solves the imbalance between demand and supply.
Therefore the economy is always in equilibrium. The resources are always fully utilized and
optimally used. The level of output and employment is maximum. They felt that there is no need
for the government to intervene. They felt that the economy always functions at full employment
and that any imbalance is only temporary.

Then the Great Depression occurred. It was precisely in 1929 that it affected the developed
economies of the capitalistic world. Its impact continued almost for the entire decade of 1930s.
The fall in aggregate demand was so severe that investment shrunk to its minimum. There was
low income→ low demand → low investment → low level of employment → low level of
output → low income. Thus it became a vicious circle. Prices crashed, currency lost its value,
and massive unemployment prevailed. Contrary to the classical theory, no “automatic
adjustment” took place and the imbalance was not temporary. Those who were unemployed
remained unemployed. Thus, the classical theory failed. There was a need for a type of
economics which would look at the economy as distinct from individuals. Macroeconomics was
born.

J.M Keynes was the father of macroeconomics which is also called as the Keynesian economics.
He was more practical in approach than the classical economists.

Keynes was the first economist to say that automatic adjustment does not happen. It is imperative
that the government intervenes. He also said that economy may not be in equilibrium at full
employment. It can be in equilibrium at less than full employment. Full employment cannot be
taken as a matter of natural occurrence. Keynes said that the government should employ policies
to correct the imbalance or disequilibrium in the economy.

This marked the evolution of macroeconomics as a different branch of economics. Though there
is a close link/ relationship between microeconomics and macroeconomics, the solutions to
problems under one cannot be used to solve problems under the other. There are clash of laws in
micro and macroeconomics, which is why the two have to exist separately. What is logical at
the micro level may not be logical at the macro level.

For example, at the individual level, saving is a virtue. It enhances the future prosperity of the
individual. But this may not be true at the macro level. Greater saving at the level of the
economy as a whole may imply lesser expenditure. Less expenditure means less demand, less
investment and less employment. Accordingly the economy may be driven towards poverty
rather than prosperity.

There are certain economicproblems which relate to the growth and development of
thecountry. Such issues cannot be handled at the micro level. These can be handled only at the
level of the economy as a whole. For example the problems of inflation, deflation,
unemployment etc. can be solved only at the macro level. Hence there is a need for a separate
theory of macroeconomics.

1.2 Distinguish between Micro and Macro Economics

Basis Micro Economics Macro Economics

1) Meaning It is the branch of
economics which studies
individual economic
variables like individual
demand, individual supply
etc.
2) Scope Narrow scope
3) Aim It is concerned with the
study of resource allocation
and price determination. It
explains how national
income is distributed in the
economy
It is the branch of
economics which studies
economy as a whole. It
studies aggregates like
aggregate demand,
aggregate supply etc
Wider scope
It is concerned with the
study of income
determination, stabilization
and growth of economy
 4) Tools of analysis The main tools of analysis The main tools of analysis
are demand and supply are aggregate demand and
aggregate supply
5) Theories Theory of demand, theory Theory of national income,
of production, price theory of employment,
determination etc. are theory of money, general
developed from micro price level etc. are
economics developed from macro
economics
6) Output Total output of the economy Distribution of output is
is taken as given and taken as given and total
distribution of output is an output is an important
important variable variable.

1.3 Importance of Macro Economics

1) Measures economic development

2) Studies inflation and deflation
3) Helps in the formulation of economic policies
4) Helps in the comparison of one country with the other

1.4 Limitation of Macro economics

1) The problem of an individual economic unit differs from those aggregates

2) It is based on unrealistic assumption of homogenous groups but in reality there are
heterogeneous groups

1.5 Examples of Macro Economic variables

• Total output/ National output

• Total/ National Income
• Total Employment
• Aggregate Demand
• Aggregate Supply
• Total Expenditure
• Total Savings
• Total Investment
• Total Consumption
• Total Import/Export
• General Price Level
CHAPTER 2
CIRCULAR FLOW OF INCOME AND PRODUCT

TO DO:
❖ 2.1 Introduction
❖ 2.2 Inter-Sectoral Flows – Concept of Real Flows and Money Flows
❖ 2.3 Circularity of Flows: Circular Flow Model showing Real Flows and Money
Flows
❖ 2.4 Why is the flow of Income and Product called the Circular
❖ 2.5 Expansion and Contraction of Circular Flow: Injections and Leakages
❖ 2.6 Two Sector Model with Savings / Financial System
❖ 2.7 Three Phases of Circular Flow
❖
2.1 Introduction

The flow of production, income and expenditure is called as the circular flow.

Production gives rise to income, income gives rise to demand for goods and services and demand
in turn gives rise to expenditure. Expenditure leads to further production.

Thus the flow of production, income and expenditure becomes circular with nobeginning or
no end. This flow is shown in the following diagram-

Production Income

Expenditure

Diagram Showing Circular Flow of Income

Circular flow of income and product thus refers to the flow of money income or the flow of
goods and services across different sectors of the economy in a circular form.

Money income or goods and services flow across different sectors because one sector depends on
the other sector. For example, households depend on the producers for the supply of goods and
services, and producers depend on the households for the factors of production.

The interdependence between the different sectors of the economy helps us to understand the
level of macro-economic variables in the economy, i.e. the level of production, consumption,
investment etc. Knowledge of macroeconomic variables shows the level of economic activity in
the economy. It indicates the level of growth and development.

2.2 Concept of Money Flow and Real Flow –

Real Flow Money Flow

1) Real flow of income implies the flow of
factor services as labour, capital, land and
entrepreneurship from the household
sector to the producing sector.
Households are the owners of factors of
production
2) There is a corresponding flow of goods
and services from the producing sector
to the household sector. Thus in
expression of real flow money does not
come into picture.
1) Money flow refers to the flow of factor
income, i.e. rent,interest,profit and wages
from the producing sector to the
household sector as monetary rewards
for their factor services (land, capital,
entrepreneurship and labour respectively)
2) The households spend their incomes
on the goods and services produced by
the producing sector. Accordingly, money
flows to the producing enterprises as
household expenditure.

2.3 Circular Flow Model showing Real Flows and Money Flows

Diagram

The
inner
2

arrows indicate the real flows and the outer 2 arrows reflect money flows.
There are 2 markets product market and the factor market

The Circular Flow of Income in a Two Sector Economy:-

1) Assumptions –
 1. There are only 2 sectors in the economy i.e. firms and households
2. Households supply factor services to firms and firms hire factor services from households
3. Household spend their entire income on consumption.
4. Firms sell all that is produced to the household
5. There is no government or foreign trade.

2) The economic interdependence between the household and firm are as follows
1. The household sector supply factor services to the firms and firms sell that is produced to
the household. Therefore whatever is produced by the firm is consumed by the
households.
2. This type of flow – flow of factor services from the household to the firm and flow of
goods and services from firms to households is known as Real flow.
3. Household receive their income in the form of wages, rent interest and profit for
providing factor services to firms. The household spend their income for the purchase of
goods and services from the firms.
4. The consumption expenditure of the household will be equal to the money received by
the firm.
5. Thus the payment made by the firm for the services of factors of production will come
back to the firm in the form of payment for goods and services. This flow of income is
called as money flow.

3) Two sector circular flow model offers following observations –

1. Total production of goods and services by the firms = Total consumption of goods
and services by the households
2. Factor payment by firms = Factor income of the household sector
3. Consumption expenditure of household sector = Income of household sector
4. Real flows of production and consumption of firms and households = Money flows of
income and expenditure of firms and households.

4) What does the Circular Flow Model show –

1. Value of goods and services produce in the economy during a given period. This is
national product
2. Income generated in the economy in the form of rent, interest, profit and wages during a
given period of time. This is national income.
3. Value of goods and services (national product) is exactly equal to income generated
(national income)
Thus, national product = national income
4. All goods and services produced in the economy are ultimately purchased.
Thus, value of goods and services = expenditure on goods and services.
Explain the circular flow of income (Delhi 2009, Foreign 2010)

2.4 Why is the flow of Income and Product called the Circular Flow –
It is because of the following two reasons –
 1) Corresponding to each real flow in one direction, there is a money/ income flow
from the other direction – Example: Corresponding to the flow of factor services which
is a real flow from the household to the producer sector, there is a flow of factor payment
which is a money flow from producer to the household sector.
2) Receipts and payments of two sectors are of equal value – In case receipts are less
than the payments or payments are less than receipts, circularity is bound to stop at one
point or the other.
Important

All goods and services produced in the economy during an accounting year may not be sold during the year
itself. Thus the value of goods and services produced may be greater than the value of goods and services
actually sold in the market. Therefore the income generated in the economy is not entirely converted into
expenditure. A part of the income is not spent (or it is saved).

In such a situation how do we say Production = Income = Expenditure?

Here comes an important assumption. While estimating national product, we always treat unsold stock of
the year as purchase by of the producers themselves.

Accordingly total expenditure during the year becomes equal to the value of goods and services produced
the year, and also become equal to income generated during the year. Thus, Expenditure = Production =
Income

2.5 Concept of Leakages and Injections in the Circular Flow of Income

Injections
1) These are those flow variables which
cause an increase in the process of
production/ income generation in the
economy
2) These variables are: (i) Investment
(ii) Exports (iii) Consumption
Expenditure by the households or the
government.
Basically all these are expenditure
variables i.e. expenditure on the goods and
services produced in the economy.
3) These variables affect the economy in 2
ways: (i) Add to the production capacity
of the economy (ii) Generate demand for
the produced goods and services.
Accordingly, the growth process is speeded
up.
Leakages
1) These are the flow variables that have a
negative impact on the process of
production/ income generation in the
economy
2) These variables are: (i) Savings
(ii) Imports (income of foreign firms will
increase as people spend on imported
goods instead of on domestic goods)
(iii) Taxes by the government
3) All these variables reduce the flow of
income in the economy; hence they are
called withdrawals or leakages.

2.6 Two Sector Model with Savings / Financial System

Question) Explain macro-economic equilibrium between households and business sector with
saving and investment (in a 2 sector model)

Households tend to save a part of their income. Emergence of savings implies the emergence of a
financial system. Financial system is the existence of a money market (and capital market) in the
economy along with various financial intermediaries such as commercial banks, insurance
companies; stock exchange etc. These financial intermediaries serve as a link between savers and
investors. Those who save park their funds with the financial intermediaries and those who
invest, borrow funds from the financial intermediaries.

The activity of saving and borrowing for investment is reflected in the circular flow model
shown below
Diagram

We assume that Saving (S) during the year is converted to Investment (I) during the year.

The above model gives the following information –

1) All income (Y) is not converted into consumption expenditure (C) but a part of it is also
saved (S). Therefore -
Y=C+S

2) Savings (S) is converted into investment (I) which is the expenditure by the producers.
Therefore –
S=I

3) If Y = C +S and S = I, we can conclude that:

Y=C+I
• Y = C + S shows factor incomes generated during the year

• Y = C + I shows expenditure on goods and services during the year.

Therefore we can say that:

Production = Income generated (in terms of C + S) = Expenditure (in terms of C+I)

2.7 Three Phases of Circular Flow

1) Production Phase -
It refers to the production of goods and services by the producer sector. It is the real flow if
considered in terms of quantum of goods and services produced. It is a money flow in terms of
the market value of goods produced

2) Distribution Phase -
It corresponds to the flow of income in terms of rent, interest, profit and wages from the
producer sector to the household sector. It is a money flow

3) Disposition Phase -
Disposition means expenditure. This phase refers to expenditure on the purchase of goods and
services by the households and the other sectors in the economy. This is money flow from other
sectors to the producer sector.

• The phases of production, distribution and disposition form a circularity (circular flow) as
one phase is the consequence of the other phase.
• Thus production generates income, income implies expenditure and expenditure leads to
further production.

Question Bank
1) What is meant by the circular flow of income and product?
2) Define monetary flow.
3) Define real flow.
4) Name the factors of production and their remuneration.
5) Who are the owners of factors of production?
6) Why are money flows opposite to the real flows?
7) What is financial system?
8) What are injections into the circular flow?
9) What are withdrawals from the circular flow?
10) Draw a 2 sector circular flow model without a financial system.
11) Distinguish between money flows and real flows.
12) What are the 3 phases of circular flow of income and product?
13) How are producers and households dependent on each other in a circular flow model?
14) State 2 basic principles of circular flow of income and product
Answer: The 2 basic principles of circular flow of income and product are:-
1. Real flows in terms of goods and services are the opposite of money flow, thereby
causing a circular flow
2. Flow of income across different sectors always implies the identity between
payments and receipts.
 15) Explain why is saving treated as a leakage in a circular flow model
Answer: A withdrawal / leakage consist of any part of income generated in producing the
national output which is not passed on within the system. Saving constitutes such a
withdrawal. Saving refers to that part of the income which is not spent. They have a negative
impact on the process of production/ income generation in the economy

High Order Thinking Skills

In the context of circular flow models, when is income = consumption
Or
Why should the aggregate final expenditure (consumption) of an economy be equal to the
aggregate factor payments (income)? Explain

• In a simple 2 sector model economy without government sector, external sector

and without any financial system, the aggregate final expenditure of an economy
would be equal to the aggregate factor payments. In other words income will be
equal to consumption.

• In this simplified economy, there is only one way in which the households may
dispose off their earnings i.e. by spending their entire income on goods and
services produced by the domestic firms. The other channels of disposing off their
income are closed.

• We have assumed that households do not save since money market or capital market
does not exist, they do not pay taxes to the government since there is no government
sector and they do not buy imported goods since there is no external sector.

• In other words, factors of production use their remuneration to buy the goods and
services which they helped in producing.

• The aggregate consumption by the households in the economy = aggregate

expenditure on goods and services produced by he firms in the economy

• The entire income of the economy therefore comes back to the producers in the form
of sales revenue. There is no leakage from the system.

• There is no difference between the amounts that the firms had distributed in the form
of factor payments/ income and the aggregate consumption expenditure that they
receive as sales revenue.