MACROECONOMICS:

Macroeconomics is the study of the aggregate economy, or the macro economy. It

examines an economy as a whole with a view to understanding the interaction between
economic aggregates such as national income, employment and inflation.

Macroeconomics, as the study of the aggregate economy, is concerned with aggregate

types of problems and issues. The most important problems--unemployment, inflation,
and stagnant production--relate to the three macroeconomic goals of full employment,
stability, and economic growth.

Unemployment, commonly measured by the average unemployment rate, indicates the

portion of the economy's total resources that are not being used for production. Inflation,
measured by the inflation rate, indicates whether the average level of prices are rising,
falling, or remaining stable. Problems related to aggregate production are measured by
gross domestic product, especially relative to potential gross domestic product.

The study of macroeconomics is filled with several competing theories. The dominant
theory used in modern macroeconomic analysis is the aggregate market, or AS-AD
model. It combines features of Keynesian economics and classical economics. Other
macroeconomic theories include monetarism, rational expectations, neo-Keynesian
economics, supply-side economics, and new classical economics, etc. These theories
often differ based on the macroeconomic phenomena and underlying political systems.

The modern study of macroeconomics is an explanation of and remedy for, economic

problems through economic policies. The two most common macroeconomic policies are
fiscal policy and monetary policy. Fiscal policy seeks to stabilize the business cycle using
government expenditures and taxes. Monetary policy seeks to stabilize the business cycle
using the money supply and interest rates.

AGGREGATE DEMAND

Aggregate demand, also called total spending, is the total amount of goods and services
demanded in the economy during a specific time period, usually a year, at a given overall
price level. It's simply the sum of all individual demands.

The aggregate demand is the demand for the GDP of an economy, therefore the AD
function is notated as AD, or Yd = C + I + G + NX. This function shows that the
aggregate demand equals to the sum of consumption(C), investment(I), government
spending(G) and the net export (NX = X - M). So in essence, it is the same with that of
GDP. AD increases when buyers possess more money or the overall price level declines.

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In conjunction with aggregate supply, aggregate demand largely determines how an
economy works, at its full strength or slackly untamed with complaining people
everywhere.

The factors affecting any component of aggregate demand can be found in the aggregate
expenditure below:

 Factors affecting Consumption

 Factors affecting Investment
 Factors affecting Government Expenditure
 Factors affecting Net Exports

AGGREGATE SUPPLY

Aggregate supply, also total output, is the total amount of goods and services supplied or
produced by an economy in a given period of time, usually a year, at a given overall price
level. It can be drawn in a schedule as a curve representing all possible AS and price level
combinations, showing in positive relationships.

Factors affecting AS includes technological innovations, changes in wages, production

costs and so on.

What are the Factors Affecting Short Run Aggregate Supply?

Ultimately, short run aggregate supply is affected by the change in unit costs of
production, that is the cost of producing on unit of good or service in an economy.

 Productivity - the level of labour, capital and Multifactor productivity. Higher

level of productivity means goods and services are being produced more
efficiently, decreasing unit costs of production, increasing aggregate supply
 Labour Wage Costs - higher wage costs means that an economy produces less
goods and services due to higher costs of production.
 Taxes and other costs - costs such as regulation and taxation costs can place a
burden on the unit costs of production, lowering the aggregate supply of an
economy
 Material Prices - higher material prices and other inputs will increase the unit
labour costs of production and lower aggregate supply. Material prices can also be
imported which is affected by changes in the exchange rate.

What are the Factors Affecting Long Run Aggregate Supply?

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  Size of labour force
 Stock of Capital - the amount of capital available in an economy.
 Productivity - higher level of productivity will mean increases in both short term
and long-term supply
 Level of Technology - The potential output of an economy can be increased
through the adaption of new technology, ideas and managerial processes, which
can increase the efficiency of resources, thus increasing long run aggregate supply

In summary, aggregate supply is a reflection of productive capacity, production costs

and overall price level, representing the supply side performance of an economy.
While long-run aggregate supply is determined by potential productive capacity, or
established technology plus the total quantity of factors (land, labor, capital) available for
production, short-run aggregate supply vibrates by reason of fluctuations in demand. In
short-term, producers respond to demand shift by either increase quantity of inputs (land,
labor, capital) or decrease it. But as you see, they are all limited in a given period of time,
so the short-run AS always come and go not far from the long-run AS. Aggregate
demand and aggregate supply are the 2 driving forces of all economies

BUSINESS CYCLE

Business cycle or economic cycle is a recurring sequential pattern of aggregate economic

activity typically characterized by recession, recovery, growth or expansion, reflecting
the fluctuation of economic performance. Business cycles usually last 2 to 10 years,
varying in frequency, magnitude and duration. Aggregate economic activity is indicated
by GDP, which in turn, is largely affected by aggregate demand, unemployment and so
forth.

Phases of a Business Cycle:

1. Prosperity:

Once the forces of revival get strengthened the level of economic activity tends to reach
the highest point—the peak. A peak is the top of a cycle. The peak is characterized by an
all-round optimism in the economy—income, employment, output, and price level tend to
rise. Meanwhile, a rise in aggregate demand and cost leads to a rise in both investment
and price level. But once the economy reaches the level of full employment, additional
investment will not cause GNP to rise.

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On the other hand, demand, price level, and cost of production will rise. During
prosperity, existing capacity of plants is overutilized. Labour and raw material shortages
develop. Scarcity of resources leads to rising cost. Aggregate demand now outstrips
aggregate supply. Businessmen now come to learn that they have overstepped the limit.
High optimism now gives birth to pessimism. This ultimately slows down the economic
expansion and paves the way for contraction.

2. Recession

Like depression, prosperity or peak, can never be long-lasting. Actually speaking,

the bubble of prosperity gradually dies down. A recession begins when the
economy reaches a peak of activity and ends when the economy reaches its trough
or depression. Between trough and peak, the economy grows or expands. A
recession is a significant decline in economic activity spread across the economy
lasting more than a few months, normally visible in production, employment, real
income and other indications. During this phase, the demand of firms and
households for goods and services start to fall. No new industries are set up.
Sometimes, existing industries are wound up. Unsold goods pile up because of
low household demand. Profits of business firms dwindle. Output and
employment levels are reduced. Eventually, this contracting economy hits the
slump again. A recession that is deep and long-lasting is called a depression and,
thus, the whole process restarts.

3. Depression or Trough

The depression or trough is the bottom of a cycle where economic activity

remains at a highly low level. Income, employment, output, price level, etc. go
down. A depression is generally characterized by high unemployment of labour
and capital and a low level of consumer demand in relation to the economy’s
capacity to produce. This deficiency in demand forces firms to cut back

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 production and lay-off workers. Thus, there develops a substantial amount of
unused productive capacity in the economy. Even by lowering down the interest
rates, financial institutions do not find enough borrowers. Profits may even
become negative. Firms become hesitant in making fresh investments. Thus, an
air of pessimism engulfs the entire economy and the economy lands into the phase
of depression. However, the seeds of recovery of the economy lie dormant in this
phase.

4. Recovery:

Since trough is not a permanent phenomenon, a capitalistic economy experiences

expansion and, therefore, the process of recovery starts. During depression some
machines wear out completely and ultimately become useless. For their survival,
businessmen replace old and worn-out machinery. Thus, spending spree starts, of
course, hesitantly. This gives an optimistic signal to the economy. Industries
begin to rise and expectations tend to become more favourable. Pessimism that
once prevailed in the economy now makes room for optimism. Investment
becomes no longer risky. Additional and fresh investment leads to a rise in
production. Increased production leads to an increase in demand for inputs.
Employment of more labour and capital causes GNP to rise. Further, low interest
rates charged by banks in the early years of recovery phase act as an incentive to
producers to borrow money. Thus, investment rises. Now plants get utilized in a
better way. General price level starts rising. The recovery phase, however, gets
gradually cumulative and income, employment, profit, price, etc., start increasing.
5. Expansion:
 Large volume of production and trade
 High level of employment
 High level of income
 Reduces general and competitive price levels
 High marginal efficiency of capital
 Favourable interest rates

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  Large expansion of bank credits
 High level of real investment
 A rise in the general level of wages and profits

Possible causes of business cycles include:

 Political power
 Rise and decline in supply of labor due to workers illusions
 Innovation
 Monetary supply
 Supply shocks

INVESTMENT

Investment refers to the act of buying capital goods that are expected to generate income
or appreciate in future. It's related to saving or deferring consumption. In terms of
macroeconomics, investment is the production per unit time of goods which are not
consumed but are to be used for future production. Gross investment minus capital
depreciation is net investment. Gross private domestic investment is comprised of
spending on new capital goods and additions to inventories. Residential construction
bought by individuals or households for home may appear to be consumption, but it's
actually included in the gross private domestic investment. In terms of finance, however,
investment bears a slightly different meaning from that of macroeconomics. For example,
if you withdraw $1,000 dollars from your bank account to buy securities, there's no
economic investment but just your personal financial investment because no capital
goods are placed for production.

MACROECONOMIC PROBLEMS:

The primary problems are unemployment, inflation, and stagnant growth.

Macroeconomic theories are designed to explain why these problems emerge and to
recommend corrective policies.
Macroeconomic problems arise when the macro economy does not satisfactorily achieve
the goals of full employment, stability, and economic growth. Unemployment results
when the goal of full employment is not achieved. Inflation exists when the economy
falls short of the stability goal. These problems are caused by too little or too much
demand for gross production. Unemployment results from too little demand and inflation
emerges with too much demand. Stagnant growth means the economy is not adequately
attaining the economic growth goal.

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1) Unemployment

Unemployment arises when factors of production that are willing and able to produce
goods and services are not actively engaged in production. It also means that the
economy is not attaining the macroeconomic goal of full employment. Unemployment is
a macroeconomic problem because:

 Less output is produced and thus the economy is less able to address the scarcity
problem.
 The owners of unemployed resources receive less income and thus have lower
living standards.

2) Inflation

Inflation arises when the average price level in the economy consistently and persistently
increases. In other words, prices generally rise from month to month and year to year and
the economy does not attain the stability goal.

Inflation is an average increase in prices, with some prices rising more than the average,
some raising less, and some even declining. As such, not every member of society is
likely to experience exactly the same inflation. Inflation is a problem because:

 The purchasing power of financial assets such as money declines, which reduces
financial wealth and lowers living standards.
 Greater uncertainty surrounds long-run planning, especially the purchase of
durable and capital goods.
 Income and wealth can be haphazardly redistributed among sectors of the
economy and among resource owners.

3) Stagnant Growth

The problem of stagnant growth arises because the supply of aggregate production is not
increasing at a desired rate or is even declining. An increase in the total production of
goods and services is generally needed to keep pace with an increase in the population.
Stagnant growth exists if total production does not keep pace, implying that the
macroeconomic goal of economic growth is not attained.

Stagnant growth is explained by the quantity and quality of the resources used for
production.

 Quantity: The available quantities of the four factors of production--labor,

capital, land, and entrepreneurship--can restrict the growth of production. The

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 quantity of labor is based on both the overall population and the portion of the
population willing and able to work. Should either decline, then growth is not
likely to keep pace with expectations. The quantity of capital depends on the
amount of investment expenditures relative to the depreciation of the existing
capital stock. If investment expenditures decline or depreciation increases, then
the economy is less likely to grow.

Quality: The quality of the production resources can also lead to stagnant growth.
The common resource quality influences are technology and education. The lack
of technological progress and allocation of fewer resources to education can limit
resource quality.

Efficiency – Technical and allocatively efficiency

SECTORS OF AN ECONOMY
The aggregate sectors of the macro economy reflect key macroeconomic functions. There
are four aggregate macroeconomic sectors that form the foundation for macroeconomic
analysis; the household sector, the business sector, government sector, and foreign sector.

Each sector is responsible for a different expenditure on gross domestic product:

consumption expenditures by the household sector, investment expenditures by the
business sector, government purchases by the government sector, and net exports by the
foreign sector.

 Household Sector: This sector includes the entire, wants-and-needs-satisfying

and consuming population of the economy. In a word, it includes everyone, all
consumers, all people, and every member of society.
 Business Sector: This sector contains the private, profit-seeking firms in the
economy that combine scarce resources into the production of goods and services.
It includes proprietorships, partnerships, and corporations.
 Government Sector: This sector includes all government entities that impose
resource allocation decisions, on the rest of the economy. It consists of the three
primary levels of central and local government divisions responsible for passing
and enforcing laws.
 Foreign Sector: This sector is comprised of everyone and everything outside the
political boundaries of the domestic economy. It includes households, businesses,
and governments in other countries.

Macroeconomic Functions of the Different sectors

Each of the four sectors has a distinct functional role to play in the macro economy.

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  Consumption: The primary macroeconomic function of the household sector is
the consumption of goods and services that satisfy wants and needs. Promoting
consumption by members of the household sector is, in essence, the ultimate
objective of economic activity.
 Production: The business sector exists to combine the resources used for the
production of the goods that satisfy wants and needs of the household sector. If
not for the productive efforts of the business sector, consumption would be less
satisfying.
 Regulation: The macroeconomic function performed by the government sector is
regulation. The government sector establishes the "rules of the game" and
regulates resource allocation decisions of the other sectors.
 External: The foreign sector is responsible for any and all economic activity that
transpires beyond the political boundaries of the domestic macro economy. It is
responsible for all external activity, which directly or indirectly affect national
output.

Linkage between the Macroeconomic Sectors

This is a macroeconomic model that balances no-consumption expenditure on production

(injections) and non-consumption uses of income (leakages) that is used to identify the
equilibrium level of, and analyses disruptions to aggregate production and income. First,
the household sector includes all of the consumption-seeking members of society--the
entire population. In effect, the economy exists to satisfy the wants and needs of the
household sector. Secondly, the household sector owns all of the factors of production, all
resources. Every resource, every worker, every factory, every acre of land, every risk-
taking entrepreneur is all owned by someone in the household sector. Lastly, the business
and government sectors exist to address the wants and needs of the household sector. The
business sector uses the resources owned by the household sector to produce the goods
and services consumed by the household sector. The government sector oversees the
provision of public goods and regulates economic activity so that the wants and needs of
the household sector are satisfied.

Leakages are withdrawals from the national income flow. they reduce the flow of income
in the economy.

total leakeages = saving (S) + taxes (T) + imports ( M)

Injections are additional spending from investment, government purchace and export.
These mean introduction of income into the flow of income. They increase the flow of
national income.
total injections = investment (I) +govt expend.(G) + exports (X)

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 for macroeconomic equilibrium:

total leakages = total injection

S+T+M = I+G+ X

The circular flow of income in an open economy

 The circular flow model demonstrates how money moves from producers to
households and back again in an endless loop.
 It is a model of the economy in which the major exchanges are represented as
flows of money, goods and services etc. between economic agents. It shows
connections and interactions between different sectors
 In an economy, money moves from producers to workers as wages and then back
from workers to producers as workers spend money on products and services.
 The models can be made more complex to include additions to the money supply,
like exports, and leakages from the money supply, like imports.
 When all of these factors are totaled, the result is a nation's gross domestic
product (GDP) or the national income.
 Analyzing the circular flow model and its current impact on GDP can help
governments and central banks adjust monetary and fiscal policy to improve an
economy.

Circular Flow of Income in 2 Sector Economy

The two-sector economy is a fundamental model consisting of only two sectors, firms,
and households.

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Other assumptions of this model are as follows.

1. There are no savings by the households. Whatever they earn, they spend in the
form of consumer expenditure.
2. Firms retain no profit, and whatever they earn from selling goods and services is
given back to households in wages, rent, etc.
3. There is no government interference in the money flow, i.e., there is no tax
liability on the households or regulations imposed on the movement.
4. It is assumed that it is a closed economy without any external interference from
foreign countries, i.e., there is no foreign trade.

Circular Flow of Income in a Three-Sector Economy

The three-sector economy model includes the role of government when determining
the flow of money. In this type of economy, the government plays an essential part.

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A three-sector economy model rectifies some of the drawbacks of the two-sector model
by introducing the following.

1. The government plays a pivotal role in consuming a major portion of the money
flow in taxes.
2. Hence, the flow of money follows from the firms and households to the
government in taxes.
3. The government utilizes taxes to develop infrastructure and other services like
healthcare, education, etc. So, the government pays back in terms of incentives
and purchases goods from the firms.
4. The government pays the households interest rates in government securities, pay
revisions, government jobs, etc.
5. Together, it all completes the circular movement of money.
6. If the government’s income from the taxes is less than its expenditure, it is said to
have a deficit budget.

As such, the role of government cannot be ignored in any economy because of such a
huge control it possesses over the economic cycle. Consequently, governmental
interference affects the overall economic performance of a country.

A three-sector economy does not consider the role of foreign markets, which has become
even more prevalent in the current globalized world.

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MACROECONOMIC MARKETS:

There are three sets of markets that make up the macroeconomy--product, financial, and
resource markets. These markets exchange three primary types of macroeconomic
commodities which include gross production, legal claims, and factor services. The four
macroeconomic sectors--household, business, government, and foreign--interact through
these three sets of markets.

 Product Markets: The product markets, also termed goods or output markets,
exchange the production of final goods and services, generally referred to as gross
domestic product. The buyers of this production are the four macroeconomic
sectors--household, business, government, and foreign. The seller of this
production is primarily the business sector.
 Financial Markets: The commodity exchanged through financial markets is legal
claims. Legal claims, or financial instruments, represent ownership of physical
assets (capital and other goods). Because the exchange of legal claims involves
the counter flow of income, those seeking to save income buy legal claims and
those wanting to borrow income sell legal claims.
 Resource Markets: The services of the four factors of production are traded
through resource markets. Resource markets, also termed factor markets, are used
by the business sector to acquire the factor services needed for production.
Payment for these factor services then generates income received by the
household sector, which owns the resources. Note: only factor services are
exchanged through factor markets, not the actual factors.

EXPRESSIONS OF NATIONAL INCOME

National income is the total value of a country`s final output of all new goods and
services produced in a period of one year. Income is a flow and is defined as earnings not
receipt or asset transformation. It is the sum of wages, salaries, commissions, bonuses
and other form of employee earnings before deduction of any legal contributions.

a) Gross Domestic Product (GDP): This is the total value of goods and services
produced within a country's borders in a given period of time usually a year.

GDP = C + I + G
Where C: the household sector
I : The business sector
G: The government sector

b) Gross National Product (GNP): This is the total monetary value of goods and
services produced by nationals irrespective of where they are located excluding output by

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foreign nationals in the domestic economy (net factor earnings from abroad). The GNP
equals the Gross Domestic Product plus income earned by domestic residents through
foreign investments (X) minus the income earned by foreign investors in the domestic
market (M). The (X – M) is also called the net foreign sector earnings, measured as the
difference between a nation’s value of exports and imports.
GNP = C+I+G+X-M
GNP = GDP + Net factor earnings from abroad

c) Net National Product (NNP)

This refers to Gross National Product minus depreciation.
i.e. GNP – Depreciation.

Conceptual Issues in Measurement of National Income

Disposable Income (Yd)
It is the amount of income available for an individual or household to spend after Tax
plus Transfer payments.
Yd = Y – T+ TR
Yd = Disposable income
Y = Gross income
T = Taxes
TR = Transfer payments that is, incomes from friends and relatives
Determinants of National Income
 Level of technology
 Level of capital stock
 Level of monetization of the economy
 Level of investment
 The market sizes
 The efficiency of resource utilization
 The size and quality of labour force
 Degree of political stability
 The degree of economic stability

MEASUREMENT OF NATIONAL INCOME

i) The Factor Income Method (Income Approach)

Under this approach, national income is calculated by adding up all the incomes accruing
to basic factors of production used in production of goods and services. The income
method records all the incomes received by each sector as a result of transactions that

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take place over the period of time under consideration. This will include incomes
received as wages and salaries of employees and the self-employed, money earned by
corporations, money received by the government from its activities, interest payments
received, payments from rent and so on.
i.e., NY = Rent + Wages + Interest + Profit in respect of the four sectors of the economy.
Therefore, NY= C+I+G+X-M. All transfer payments are excluded in national income
measurement to avoid double counting for example, gratuity and pocket money.

ii) The Expenditure Method

This is also known as the final product method. It measures national income at the final
expenditure stages. Expenditures include all money spent on goods and services at
market prices. These expenditures are computed and added to obtain the total value of
products finally sold. Hence, the expenditure approach involves aggregation of the
household sector expenditure (consumption), business firms’ expenditure (investment),
government expenditure (provision of social services) including net expenditure in the
foreign sector (X-M).

NE=C+I+G+X–M
iii) The Value-Added Approach/ the output method
All goods and services have a price. That price represents the value of the inputs that
went into the production of that item - land, labour, capital and enterprise. At each stage
of the production process therefore, the value of the output carried out can be recorded -
this is the value added.
We add the net value added at different stages in production of goods and services in an
economy per period of time. It is difficult to trace the intermediate stages under this
approach. The total value added is the price at which the commodity is sold. To avoid
double counting, it is only the net value that is added and not the intermediate values

Note: The three methods must yield the same results because the value of the goods and
services produced (O) must be equal to the total income paid to the factors that produced
these goods and services (Y) and the income paid to factors of production must equal to
total expenditures on goods and services (E). This is because:
Every transaction has a buyer and a seller. Every shilling of spending by some buyer is a
shilling of income for some seller. The equality of income and expenditure can be
illustrated using the circular-flow of income diagram.

Problems faced when Measuring National Income

1. Problem of double counting- This is where the output of one production process
become input to another process leading to double counting the value of the good.

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 This is because it is difficult to differentiate between intermediate goods and final
goods.
2. Errors of omission. Non marketed goods such as service of a housewife are not
counted in national income calculation.
3. Black economy- production and selling of goods and services in black economy is
illegal and these are not counted in the national income calculation although they
generate income.
4. Services of volunteers and self-provided services are not accounted for when
calculating national income.
5. There is no common method of calculation and different countries use different
methods and policies in calculating national income. This makes it difficult to make
comparisons.
6. Definition of income: It is difficult to separate income that accrues to factors of
production arising from economic activity and the transfer payments.
7. Errors of Commission: These arise because values of certain activities are not
estimated for example, effect of pollution and rate of exploitation of resources.
These affect national income figures.
8. Large subsistence sector where most activities are not valued in money terms.
9. The exercise is very expensive and some countries lack adequate qualified
personnel.

Importance of National Income Statistics

There are several important uses of national income statistics and, therefore, there is great
need for their regular preparation. National income estimates provide not only a single
figure showing the national income, but also supply the detailed figures in regard to the
various components of the national income. It is both the figure of national income and
the details regarding its various constituents that throw light on the functioning and
performance of the economy.

The following are some of the important uses of national income estimates:

1. Overall production performance of the economy

National income estimate reveals the overall production performance of the economy.
Per capita income, which is found by dividing the total national income by the
population, gives us an idea about the average standard of living of the people.
Economic welfare depends to a considerable degree on the level of national income
and the average standard of living of the people. Thus, the figures of national income
and per capita income indicate the level of economic welfare of the people of a
country.

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2. Comparing performance over time

By comparing national income estimates over a period of time, we can know whether
the economy is growing, stagnant or declining. If national income increases over
years, it means that the economy is growing. If it remains more or less unchanged, it
indicates that economy is stagnant; and if it is falling over a period of time, it
indicates that the economy is deteriorating.

In case the economy is growing, we can also judge the rate of economic growth or
development by measuring the rate of increase in national income.

3. The national income estimates show the contribution made by the various sectors of
the economy, such as agriculture manufacturing industry, trade, etc., to the national
income. That shows the overwhelming importance of individual sectors in an
economy.
4. National income estimates throw light on the distribution of national income among
different categories of income, such as wages, profits, rents, and interest. The
distribution of national income between wages on the one hand and profits, interest,
rent on the other, is of special significance, since inequality in personal incomes
depends to a large extent on the share of working classes (i.e., wages) and the share of
property owners (i.e., rents, profits and interest).
5. The national income estimates also contain the figures of consumption, saving and
investment in the economy. Information regarding consumption, saving and
investment is essential for any economic study concerning economic growth and
planning. It is the rate of saving and investment in the economy that determines the
rate of economic growth.
6. With the help of national income estimates of various countries of the world, we can
compare the standards of living of the people living in those countries. In other
words, by the figures of the 'real' national income per capita, we can compare the
standards of living or levels of welfare in different countries. Moreover, developed
and under-developed countries are usually classified on the basis of per capita
income.
7. National income estimates are a valuable guide to economic policy especially in
development planning and active government intervention in the economy. By
looking at national income statistics, the government can decide if the economy or its
various actors need any stimuli or regulation. From the national income estimates we
can see the part played by the government in the national economy.
8. National income figures are used as a measurement of the standard of living of people
where; a higher per capita income would indicate higher standard of living in a
country.

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 Per capita income (PCY) is calculated by dividing the total income by the
population of the country.

Total National Income

PCY =
Total Population

Limitations of using per capita income as a measure of standard of living

One of the main uses of national income data is measuring the economic wellbeing of the
population through the concept of the standard of living. The basic standard for this is to
use per capita income; however, this has some limitations:

1. Regional Variations in income and spending

National income figures hide significant regional variations in output, employment and
incomes per head of population.

Within each region there are also areas of relative prosperity contrasting with
unemployment black-spots and deep-rooted social and economic deprivation.

See the revision pages on the north south economic divide

2. Inequalities of income and wealth

GDP figures on their own do not show the distribution of income and the uneven spread
of financial wealth. Incomes and earnings may be very unequally distributed among the
population and rising national prosperity can still be accompanied by rising relative
poverty.

3. Economic growth and externalities

Rising national output might have been accompanied by an increase in pollution and
other negative externalities which have a negative effect on economic welfare. Output
figures also tell us little about the quality of goods and services produced

4. Leisure and working hours

Rising national output might have been achieved at the expense of leisure time if workers
are working longer hours.

5. The balance between consumption and investment

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We need to analyze the balance between consumption and investment. If an economy
devotes too many resources to satisfying the short run needs and wants of consumers,
there may be insufficient resources for investment needed for long term economic
development.

6. Over exploitation of resources

Faster economic growth might improve living standards today but lead to an over-
exploitation of scarce finite economic resources thereby limiting future growth
prospects.

7. The black economy and non-monetized sectors

GDP figures might understate the true living standards because of the existence and
growth of the black economy. The black economy includes economic activity that goes
unrecorded by the Inland Revenue.

8. Nature of goods produced

Doesn’t take into account the type of goods produced. Some goods do not directly
improve on human welfare but increase national income and hence per capita income.

9. Movements in exchange rates may distort comparison of Per Capita Income from
one country to another.
10. Doesn’t consider the cost of living (prices for goods and services).

THEORIES OF NATIONAL INCOME DETERMINATION

The classical economists believed that in case of disequilibrium between leakages and
injections, and then prices would adjust to restore the equilibrium.

Keynesians disagree with this and they argue that the level of output (national income) to
adjust, government has to intervene to increase injections perhaps by increasing
government expenditure. Increased government would result into extra aggregate demand
and firms would employ more people. This would mean more income in the economy
some of which would be spent and some saved (or paid in tax). The extra spending would
prompt the firms in the economy to produce even more, which leads to even more
employment and there even more income. This process would go on and on until it stops.
It would finally stop because each time income increases; the level of leakages also
increases. Once leakages and injections are equal again, equilibrium would be restored.
This process is called the multiplier effect.

The Keynesian theory to income determination:

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The Two-Sector Model (The Keynesian equilibrium) under aggregate demand and
aggregate supply functions
According to Keynes, the equilibrium income under the two-sector model is determined
where aggregate demand (AD) equals aggregate supply (AS)
Aggregate supply refers to the total value of goods and services produced and supplied in
the economy per period of time. Aggregate demand refers to the total value of goods and
services purchased in a given economy per period of time. If all that is produced is sold,
then aggregate supply grows at a constant rate of increase in income (Y). i.e.
AS =Y
But Y= C + S
Hence AS=Y=C+S
Aggregate Supply Function (AS)

Aggregate Demand Function (AD)

In a two-sector model, aggregate demand is composed of demand by the household sector
and the business sector. I.e., it has two components.
i) Aggregate demand for consumption goods (C) i.e., demand by the household.
ii) Aggregate demand for capital goods (I) i.e., demand by the businesses
Therefore, in the two-sector model, AD = C + I
In Keynesian theory framework, consumption is a function of income i.e. C = (Y).
However, the consumption function may be denoted as C = a + bY
Where a = Consumption at zero income i.e., autonomous consumption
(Autonomous consumption)
b= the marginal propensity to consume

The Consumption Function (C)

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Investment Function
According to Keynes, investment is said to be Autonomous. I.e., The level of investment
doesn’t depend upon the level of income. I = Io
Illustration of the investment function

The Aggregate Demand Function (AD) = C+I; this is vertical summation of the
investment and investment functions as illustrated below:

The Keynesian equilibrium using (AD =AS) can be graphically illustrated as below

2. The classical approach (leakages are matched with injections)

S=I

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The savings function

Illustration of the Savings Function

The Keynesian equilibrium using savings and investment approach (illustration)

Calculation of national income in a two, three and four sector model

Given that C=300+ 0.8Y, I=200
Determine
i. The equilibrium level of national income
ii. The level of consumption expenditure
iii. The level of investment.
iv. The level of savings
v. The level of autonomous expenditure

NB: Derivations and Illustrative Examples of National Income determination for all
the sectors will be done in class.

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