Course: ACTGE03 Paper: Macro Economics Unit I

UNIT I: INTRODUCTION

1. What do you mean by Macro Economics? Highlight its importance and differentiate it from
Micro Economics.

Meaning of Macro Economics

It is that part of economic theory which studies the economy in its totality or as a whole. It studies
not individual economic units like a household, a firm or an industry but the whole economic system.
Macroeconomics is the study of aggregates and averages of the entire economy. Such aggregates are
national income, total employment, aggregate savings and investment, aggregate demand, aggregate
supply general price level, etc.
Here, we study how these aggregates and averages of the economy as a whole are determined and
what causes fluctuations in them. Having understood the determinants, the aim is how to ensure the
maximum level of income and employment in a country.
In short, macroeconomics is the study of national aggregates or economy-wide aggregates. In a
way it is like study of economic forest as distinguished from trees that comprise the forest. Main tools
of its analysis are aggregate demand and aggregate supply.
Since the subject matter of macroeconomics revolves around determination of the level of income
and employment, therefore, it is also known as ‘Theory of Income and Employment.’

Definition
• Prof. Kenneth E. Boulding: “Macro Economics deals not with individual quantities as such but
with the aggregates of these quantities, not with income but with national income, not with
individual price but with the general price-level, not with individual output but with national
output.”
• Prof. Gardener Ackley: “Macro Economics concerns itself with such variables as the aggregate
volume of the output of an economy, with the extent to which its resources are employed, with the
size of the national income, with the general price level.”
• Prof. Carl Shapiro: “Macro Economics deals with the functioning of the economy as a whole.”

Importance of Macroeconomics
i) Functioning of an Economy: Macroeconomic analysis gives us an idea of the functioning of an
economic system. It is very essential for a proper and accurate knowledge of the behaviour
pattern of the aggregative variables as the description of a large and complex economic system is
impossible in terms of numerous individual items.
ii) Formulation of Economic Policies: Macroeconomics helps in the formulation of economic
policies. Governments deal not with individuals but with groups and masses of individuals,
thereby establishing the importance of macroeconomic studies.
iii) Understanding Macroeconomics: The study of macroeconomics is essential for the proper
understanding of microeconomics. No Microeconomic law could be framed without a prior study
of the aggregates. In other words, both Micro and Macro economics are interrelated.

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iv) Business cycles: Boom and depression in the levels of income and employment follow one
another in a cyclical fashion, while income rises and employment expands during boom period,
they shrink during depression. Discussion of business cycle’s general and anti-depression policies
in particular, fall within the scope of macro economics.
v) Inflation and Deflation: Macroeconomic approach is of utmost importance to analyse and
understand the effects of inflation and deflation. Different sections of society are affected
differently as a result of changes in the value of money. Macroeconomic analysis enables us to
take certain steps to counteract the adverse influences of inflation and deflation.
vi) Study of National Income: It is the study of macroeconomics which has brought forward the
immense importance of the study of national income and social accounts. In micro-economy such
a study was relegated to the background. It is the study of national income which enables us to
know that three-fourth of the world is living in abject poverty. Without a study of national
income, as a result of the development in macroeconomics, it was not possible to formulate
correct economic policies.
vii) Study of Economic Development: As a result of advanced study in macroeconomics, it has
become possible to give more attention to the problem of development of underdeveloped
countries. Study of macroeconomics has revealed not only the glaring inequalities of wealth
within an economy but has also shown the vast differences in the standards of living of the people
in various countries necessitating the adoption of important steps to promote their economic
welfare.
viii) Performance of an Economy: Macroeconomics helps us to understand and analyse the
performance of an economy. It implies the result-oriented study of an economy—in terms of
actual and factual achievements. Gross National Product (GNP) or National Income (NI)
estimates are used to measure the performance of an economy over time by comparing the
production of goods and services in one period with that of the other periods the composition of
GNP gives information about the quantum of contribution of each sector of the economy to
GNP.
ix) Nature of Material Welfare: Macroeconomics enables us to study the nature and size of the
material welfare of the nations. The problem of measuring social welfare is not easy; even
welfare economics does not help us. Those who are interested in the material and social welfare
of all must study problems in their macroeconomic setting. This adds to the importance of
macroeconomics because when the chief objective of the studies of economics is the welfare of
entire society, economics becomes the study of macroeconomics.

Difference between Micro Economics and Macro Economics

Basis Micro Economics Macro Economics
Meaning Microeconomics studies the Macroeconomics studies the whole
particular market segment of the economy, that covers several market
economy segments
Deals with Microeconomics deals with various Macroeconomics deals with various
issues like demand, supply, factor issues like national income,

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pricing, product pricing, economic distribution, employment, general

welfare, production, consumption,
etc.,
Business Applied to internal issues
Application
Scope Covers several issues like demand,
supply, factor pricing, product
pricing, economic welfare,
production, consumption, etc.
Significance Useful in regulating the prices of a
product alongside the prices of
factors of production (labour, land,
entrepreneur, capital, etc) within the
economy
Limitations It is based on impractical
presuppositions, i.e. In
microeconomics, it is presumed that
there is full employment in the
community which is not at all feasible
price level, money, etc.,
Environment and external issues
Covers several issues like
distribution, national income,
employment, money, general price
level, etc.,
Perpetuates firmness in the broad
price level and solves the major
issues of the economy like deflation,
inflation, rising prices (reflation),
unemployment and poverty as a
whole
It has been scrutinized that
Misconception of Composition’
incorporates, which sometimes fails
to prove accurate because it is
feasible that what is true for
aggregate (comprehensive) may not
be true for individuals too

After making the above distinction, we can come to the conclusion that these two concepts are
not antithetical but complementary to each other and they are bound to go hand in hand.

2. Discuss the key Macroeconomic Variables in detail.

Introduction
Macro economics is the study of several conditions of an economy. In other words, it deals with
aggregates such as total employment, total consumption, total savings, total investment and so on.
This branch of economics is also called “aggregate economics,” which indicates that it deals with the
sum total of the problems of entire economy rather than an individual.
Macro economic variables are indicators that signal or point to the current trends in the economy.
The Government needs to study, analyse and understand the major variables that determine the
current behaviour of the whole economy. The Government should understand the forces of economic
growth, why and when recession or inflation occur and anticipate these trends so as to formulate
suitable policies to strengthen the economy.

Important macroeconomic variables

i) Unemployment: One of the major issues in macroeconomics is to explain and determine the
level of employment in an economy and find out the causes of unemployment. The

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unemployment problem in India is very critical and fluctuates year after year depending upon the
economic conditions of the country.
ii) Poverty: The level of poverty is also considered as one of the important variable of
macroeconomics. Like unemployment, the problem of poverty fluctuates year after year
depending upon the economic condition of the country. It is of utmost importance for the
Government to reduce the level of poverty, if economic growth of the country is to be raised.
iii) National Income: It is the value of all final goods and services in a country in year. The level of
national income shows the performance of the economy in a year and determines the overall
living standard of the people of the country. The higher the per capita national income, the greater
the amount of goods and services available for consumption per individual on an average.
Recession in the economy not only results in unemployment, but also fails to determine the actual
level of national income. The fluctuations in the economic activity results in changes in national
income and employment.
iv) Inflation: The inflation rate can be used to measure changes in the average price level based on a
price index. The most commonly know index is the consumer price index (CPI). This index
measures average retail prices that consumers pay. A high or increasing CPI indicates that
existence of inflation. Higher prices tend to reduce overall consumer spending, which in turn
leads to a decrease in GDP. While inflation itself is not always negative, rapidly increasing rates
of inflation is an indication of poor macroeconomic health.
v) Economic Growth and Development: Economic growth is the amount that the level of output
within an economy increases over a given time period (usually measure over a year). Economic
growth is extremely desirable as it means that, in general, the people within an economy are
getting richer. Economic growth can be increased in a number of ways, such as technological
improvement, an increase in the demand for goods and services, and an increase in the size of the
workforce (a fall in unemployment).
vi) Economic output: Economic output or income is measured in terms of the gross domestic
product (GDP), which is the combined earnings from a year’s worth of goods and serviced
produced by a country. A higher rate tends to indicate a more economic rich country.
vii) Circular Flow of Income: The circular flow of income represents how money moves through
society. Money flows from producers to workers as wages and flow back to producers as
payment for products. In short, an economy is an endless circular flow of money. The circular
flow of income affects households or firms as it provides the income that workers need to live
and the revenue that business need to run.

3. Describe the Circular Flow of Income in a Two-Sector Model.

Introduction

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There are four economic activities - production, consumption, distribution and exchange. These
activities generate income. This income flows continuously among various sectors of the economy.
This is known as circular flow of income.
In order to illustrate circular flow of income, economy is divided into four sectors – household
sector, business sector/firms, Government and the rest of the world.
In order to study circular flow of income in a simplified way, we combine four sectors to make
the following three models of circular flow:
a) Two-Sector Model: It consists of households and business sectors.
b) Three-Sector Model: Consisting of household, business and Government sector. It is also called
Closed Economy.
c) Four-Sector Model: Consisting of household, business, Government sector and the rest of the
world. It is known as Open Economy.

Circular Flow of Income in a Two-Sector Model

The Two-Sector Model consists of households and firms. Household sector owns all factors of
production. Firms use factors to produce goods and services. The household sector sells the factor
services to the firms and receives income from them in the form of wage, rent, interest and profit.
Firms use factors to produce goods and services. The household sector pays for goods and services in
the form of money and thereby firms receive money from households.
Circular flow of income can be viewed from two different angles: Real Flow and Money Flow.

(a) Real Flow

In the economy, the flow of factor services from households to business and the flow of goods
and services from business to household is called the real flow. There are two sectors – households
and firms.

Factor Services (Factors of Production)

Land, labour, capital and enterprise

Households Firms

Goods and Services

Factors of production (land, labour, capital and enterprise) flow from households to producers.
Goods and services are produced. And these goods and services flow from producers to households.
This is the real flow.

(b) Money Flow

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The flow of monetary payment from business to household for their factor services and in turn
the monetary payment from households to business for goods and services is called money flow.

Monetary Payment for Factor Services

Rent, wages, interest and profit

Households Firms

Monetary Payment for

Goods and Services

When there are two sectors, business sector buys factor services from household sector.
Therefore, monetary payment in the form of rent, wages, interest and profit goes to household sector.
Household sector buys goods and from household to business sector. This flow is the monetary flow.

Explanation of Circular Flow of Income in a Two-Sector Model

(Without Financial Market)

Monetary Payment for Factor Services

Rent, wages, interest and profit
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Factor Services
Land, labour, capital and enterprise

Households Firms

Goods and Services

Payment for Goods and Services

In the two-sector model, business sector produces goods and services in the product market by
getting factor services from households and pays rent, wages, interest and profit to them. So, money
flows from business to household sector. These payments are income of households, who use it in
purchasing goods and services from production units/firms. Therefore, money again flows from
household to business sector. This way, money flow from business to households and again from
households to business sector is the total money flow in the economy.
In the real flow, factor services go from households to business and goods and services from
business to households. By combining these real and money flow, we get total circular flow.

Explanation of Circular Flow of Income in a Two-Sector Model

( With Financial Market)

Consumption Expenditure

Factor Services
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Land, labour, capital and enterprise
 Course: ACTGE03 Paper: Macro Economics Unit I

Saving Borrowing [

Households Financial Market

Saving
Firms
Borrowing

Factor Payment
Rent, wages, interest and profit

Goods and Services

If the model doesn’t include Financial Market, we assume that there is no saving. Therefore, there
is no existence of Financial Market. On the other hand, the inclusion of Financial Market indicates
there is saving, both by households and business. If there is real flow from firms, there will be money
flow from households. If there is real flow from households, there will be money flow from firms.

4. Describe the Circular Flow of Income in a Three-Sector Model with Government. If

Government’s budget is deficit, how will it affect Circular Flow of Income?

Introduction
The three-sector model of circular flow consists of household sector, business sector (firms) and
the Government. In this model, the Government activities influence income flow.

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Subsidy, Gvt.
Factor Payment,
Transfer Payment Government Spending (Gvt. buys
goods and services

Taxes: Direct, Indirect Corporate Tax, GST

Deposit Borrowing

Saving Saving [

Households Financial Market

Borrowing
Firms
Borrowing
Loan

Consumption Expenditure
Payment for Goods and Services

Factor Payment
Payment for Factor Services

Explanation
The above diagram shows how the three sectors interact and form an economy. Households
provide factor services to firms and firms make factor payments to households. Firms provide goods
and services to households and households make payment to firms by way of consumption
expenditure.
Government charges tax from households. This is an income for the Government. Government
spends this income earned through taxes in the form of factor payment (salary) and transfer payment
(old-age pension, unemployment allowance, scholarship, etc.) Government also gives salary to
people. This is known as Government expenditure [on services].
There is an interaction between Government and Firms also. It imposes tax on firms (corporate
tax) and in return it provides subsidy for industrial growth. Government also buys goods and services
from firms. This is called Government spending.
If the tax revenue is less than the Government expenditure, then it will be deficit budget. In such
a situation, Government has to take loan from the capital market. It will affect income flow
positively.

Conclusion
If the Government budget is deficit, it will print additional currency. Thus, the flow of income
will not be affected immediately, except if there is a rise in prices when people are forced to curtail
expenditure and thereby tax revenue will be reduced.
If deficit is used for investment purpose, it will generate employment, income and demand. This
will result in income for the Government in the future.

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5. Define ‘National Income.’ What are the different concepts and measures of National Income?
Introduction
National income is an important macro-economic aggregate. It is a yardstick to know the
performance of an economy (whether the economy is growing or it is not performing well). National
income is calculated by the Central Statistical Organisation (Estd. 1951).

Meaning of National Income

National Income refers to the monetary value of all final goods and services produced by the
residents of a country while working both within and outside the domestic territory of a country in an
accounting year. It also includes net factor income from abroad. It is estimated by multiplying final
goods and services with their respective prices.
In simple words, national income means the sum total of the prices of goods and services
produced during a year.

Definition
Traditional Definition
• Marshall: “The labour and capital of a country acting on its national resources produce
annually a certain net aggregate of commodities, material and immaterial including services of
all kinds. This is the true net annual income or revenue of the country or national dividend.”
• A.C. Pigou: “National income is that part of the objective income of the community, including of
course income derived from abroad, which can be measured in money.”

Modern Definition
• Simon Kuznets: “National income is the net output of commodities and services flowing during
the year from the country’s productive system in the hands of the ultimate consumers.”
• Samuelson: “This (National Income) is a name which we give to the monetary measurement in
annual speed of goods and services in an economy.”

Product

Raw materials Intermediate Goods Final Goods

Resident

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Ordinarily Not Ordinarily

Y = PG + PS Where, Y = National income;

P = Price;
G = Goods;
S = Services

It is also known as national product. But when national income is measured by Income Method, it
can be defined as the sum total of factor income – rent, wages, interest and profit accruing to the
residents of a country for their productive services rendered during an accounting year.
In simple words, national income means income earned by the residents of a country from work
and property in an accounting year. It is the sum of factor income earned by the people from the
country’s productive system in the form of rent, wages, interest and profit in a year.

Contents/Variants of National Income

1) Gross Domestic Product (GDP): It is the money value of all final goods and services produced
in an economy (by all organisations and enterprises in the domestic territory) in an accounting
year. Gross Domestic Product (GDP) is the most popular method to measure national income and
economic prosperity.

Organisations

Private Public Government

Sectors

Primary Secondary Tertiary

There are both resident and non-resident producers producing goods and services within the
domestic territory of a country. For example, besides resident producers, there are various MNCs
and foreign banks operating in India. The value of their final goods and services are included in
India’s GDP. The money value of goods and services can be calculated in two ways: Market
Price and Factor Price. The aggregate of the two are included in GDP.
GDP = Market Price + Factor Cost
(a) GDP at MP (GDPMP): It is the money value of all final goods and services produced within
the domestic territory of a country in an accounting year at prevailing market price.

GDPMP = PG + PS Where P = Current year price

G = Goods

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S = Services
(b) GDP at FC (GDPFC): As we know the production of goods and services in an accounting
year is the combined efforts of various factors of production – land, labour, capital and
entrepreneurship.
Payment made to these factors of production for their contribution in the process of
production is called factor income.
Therefore, domestic product can also be estimated by taking the amount of domestic
income.

GDPFC = Domestic factor income + consumption of fixed capital

- GNPFC = only cost of production

- GNPMC = Indirect taxes added - subsidy

2) Gross National Product (GNP): It is a wider concept than GDP. It includes not only money
value of all final goods and services produced within the domestic territory of the country but
also net factor income from abroad.

GNP = GDP + Net factor income from abroad

If NFIA is positive, GNP will be greater than GDP.

For example, GNP = 1,0000 + 5,000 = 15,000
It implies that the residents of a country are earning more from abroad than the foreigners
earning from the country. But if NFIA is negative, GNP will be less than GDP. It implies that
factor income earned from other countries by the citizens of a country is less than the factor
income received by the foreigners from the said country.

3) Net Domestic Product (NDP): Net domestic product (NDP is an annual measure of the
economic output of a nation that is adjusted to account for depreciation and is calculated by
subtracting depreciation from the gross domestic product (GDP).

Net domestic product (NDP) accounts for capital that has been consumed over the year in the
form of housing, vehicle, or machinery deterioration. The depreciation accounted for is often
referred to as capital consumption allowance and represents the amount needed to replace those
depreciated assets.

NDP = GDP – Depreciation

4) Net National Product (NNP): It is the net market value of all final goods and services produced
by a country’s citizens overseas and domestically, minus depreciation.

NNP is often examined on an annual basis as a way to measure a nation’s success in continuing
minimum production standards.

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Gross Domestic Product (GDP) is the most popular method to measure national income and
economic prosperity, although NNP is prominently used in environmental economics.

NNP = MVFG + MVFS

Where, MVFG = market value of finished goods
MVFS = Market value of finished services
Or
NNP = GNP – Depreciation

5) Personal Income: The sum total income actually received by the households or individuals from
all sources is called personal income. It includes not only factor income but also different
incomes. Transfer incomes are those incomes which are received without rendering any
productive service.

Personal Income = Private Income – Corporate Tax – Undistributed Profit

Or

Personal Income = Individual Income Total - Depreciation - Undistributed Profit - Tax

6) Private Income: It refers to the income which occurs to the private sectors from all sources. It is
the income from all sources whether earned (income payments) or unearned (transfer payments).
Thus, it is the sum total of factor incomes and transfer incomes received by the private sector. It
also includes net factor income from abroad. It is the income of all enterprises and workers in the
private sector from whatever source it is received or not received by the individuals.

Private Income = Income from domestic product accruing to private sector +

Current transfer income from Govt. + Net current transfer from rest of the world +
Interest on national debt + NFIA

Current transfer income from Govt. = Household receives transfer income such as
unemployment allowances, scholarships, old-age pension, etc., from the Government. Similarly,
the producers also receive transfer income in the form of subsidies, donations, etc.

Net current transfer from rest of the world = Current transfer received from other countries –
Current transfer payment made to the rest of the world.

Interest on National Debt = Interest payment made by Govt. for borrowing funds from the
public to meet the rising expenditure.

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7) Personal Disposable Income: It is that part of personal income which is either spent on
consumption or saved by the households. It is the income which actually is at the disposal of
households. The household pays personal taxes like income tax, etc., out of their personal
income. They may also have to pay other miscellaneous items like fine, fee, etc., to the Govt.
administrative department.

PDI = PI – (Direct Taxes + Miscellaneous payment to the Govt.)

Or

PDI = Personal Income – Personal Taxes

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