Macroeconomics

Introduction
 What is Macroeconomics
 Macroeconomics is the study of the economy as a whole.
 The goal of macroeconomics is to explain the economic changes that affect
many households, firms, and markets at once.
 Macroeconomists address diverse questions:
1. Why is average income high in some countries while it is low in others?
(Aggregate Income)
2. Why do prices rise rapidly in some periods of time while they are more
stable in other periods? (Aggregate Price Level)
3. Why do production and employment expand in some years and contract in
others? (Aggregate Output and Total Employment)
4. What, if anything, can the government do to promote rapid growth in
incomes, low inflation, and stable employment?
 These questions are all macroeconomic in nature because they concern the
workings of the entire economy
 Each of the above issues is of great concern to the government
 Because the economy as a whole is just a
collection of many households and many firms
interacting in many markets, microeconomics and
macroeconomics are closely linked.
 The basic tools of supply and demand, for
instance, are as central to macroeconomic analysis
as they are to microeconomic analysis
 Much of the macroeconomics has deep roots from
the work of John Maynard Keynes in his book,
The General Theory of Employment, Interest and
Money (1936)
 The Components of the
Macroeconomy
 Macroeconomics focuses on the following groups in
the economy:
1. Households and firms (private sector)
2. The Government (public sector)
3. The Rest of the World (international sector
 The four topics of primary concern to
macroeconomics are increases in overall price level
or inflation; the level of aggregate output in the
economy; the level of aggregate employment and the
rate of unemployment; and the interrelationships of
the world economies
 The Circular
Flow of Income
 The Circular Flow Diagram
 A useful way of seeing the economic interactions among
the 4 groups in the economy is to examine the circular
flow diagram which shows the income received and
payments made.
 One of the major lessons of the circular flow diagram is
that everyone’s expenditure is someone else’s receipt or
income
 Everyone’s expenditures go somewhere. It is impossible to
sell something without there being a buyer and it is
impossible to make payment without there being a
recipient .
 Every transaction must have two sides.
 The Circular-Flow Diagram
Revenue Spending
Market for
Goods
Goods & Goods &
Services sold and Services
Services
bought

Firms
Households

Inputs for Labor, land,

production Market for and capital
Factors
Wages, rent, of Production Income
and profit
 The Circular Flow of Payments
Pu
go rcha
od se
sa o
nd f fo
lly by se reig
tica ices rvi n
ce -m
es erv s ( ad
d om d s ts) Rest of the World Im e
po
of s an por rts
se od (ex Purchase of ,M
a )
r ch go ers Goods & services
Pu ade ign
M ore
F
Purchase of Taxe
Goods & services s

Government Households
Firms
Taxes Wages, Interest,
transfer payments

Wages, Interest,
dividends and rent
 The Circular Flow of Income

INJECTIONS

Export
Firms expenditure (X)
Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)

WITHDRAWALS

Households
 The Circular Flow of Income

INJECTIONS

Export
Firms expenditure (X)
Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)

WITHDRAWALS

Households
The interdependence of goods and factor markets
(3) (2)
Factor $ $ Producer
demand supply

Factor Goods
services
P P
S S
PF 2
P2
PF 1 P1
D2 D2
D1 D1
O QF1 QF2 Q O Q1 Q2 Q

Factor
services Goods
(4)
(1)
Factor
Consumer
supply $ $ demand
 Households Income
 Households work for firms and the government and they
receive wages for their work
 The circular flow diagram shows a flow of wages into the
household sector as payment for those services.
 Household also receive interest on corporate and
government bonds and profits (dividends) from firms
 Many households receive payments from government in
form of social welfare benefits, war veteran benefits,
social security payments (NSSA) for which the recipients
do not supply goods, services or labour.
 Economists call these kind payments from government
transfer payments
 Households Expenditure
 Households spend by buying goods and services from
firms and by paying taxes to government
 These items make up the total amount paid by the
households
 The difference between the total receipts and the total
payments is the amount households save or dissave.
 Saving by households is sometimes termed a leakage or
withdrawal from the circular flow because it withdraws
income or current purchasing power from the system
 A household can dissave by using up some of its previous
savings or by borrowing.
 In the circular flow diagram, household expenditure is
shown as a flow out of the household sector.
 Firms
 Firms sell goods and services to households and
government
 These sales earn revenue, which shows up in the
circular flow diagram as a flow of funds into the
firm sector.
 Firms pay wages, interest and dividends
(profits) to households and they pay taxes to
government.
 These payments are shown as flowing out of the
firm sector
 Government
 The Government collects taxes from
households and firms.
 The government also makes payments by
buying goods and services from firms,
paying wages and interest to households
and making transfer payments to
households
 If government’s revenue is less than its
payments (budget deficit), the government
is dissaving
 Rest of the World
 Households spend some of their income on
imports (goods and services produced in the rest
of the world).
 Similarly, people in foreign countries purchase
exports (goods and services produced by
domestic firms and sold to other countries).
 Imports are withdrawals or leakages from the
circular flow while exports are injections into the
circular flow
 The Three Market Arenas
 Another way of looking at the ways
households, firms, government and the rest
of the word relate to each other is to
consider the markets in which they interact.
 The three markets are:
1. Goods and services market
2. Labour Market
3. Money (financial) market
 The Three Basic Markets

Government

Firms Rest of the World

Households

Goods and Labour Money and

Services Market Capital (financial)
Markets markets

Households, firms, the government and the rest of the world all
interact in the goods, labor and money markets
 Goods and Services Market
 Households and government purchase goods and services from
firms in the goods-and-services market.
 In this market, firms also purchase goods and services
(including capital goods) from each other.
 Firms supply to the goods and services market
 Households, the government and firms demand from this market
 The rest of the world buys and sells to the goods and services
market
 Aggregate demand is the total demand for goods and services
in an economy and aggregate supply is the total supply of
goods and services in the economy.
 A major theme in macroeconomics is the behavior of aggregate
supply and aggregate demand.
 The Labour Market
 Interaction in the labour market occurs when firms
and the government purchase labour from
households
 In this market, households supply labour and firms
and government demand labour
 Firms are the largest demanders of labour, though
government is also a substantial employer
 Labor is also supplied to and from the rest of the
world
 Money and Capital Market
 In the money market- sometimes called financial markets- households
purchase stocks and bonds from firms
 Households supply funds to this market in the expectation of earning
extra income in the form of dividends on stocks and interest on bonds
 Households also demand (borrow) funds from this market to finance
various purchases.
 Firms borrow to build new facilities in the hope of earning more in the
future
 Governments borrow by issuing bonds to finance budget deficits.
 The rest of the world also borrows and lends to the financial market.
 Much of the borrowing and lending of households and firms, the
government and the international sector is coordinated by financial
institutions- commercial banks, insurance companies, pension funds
e.t.c