ECF 110:Introduction to Macroeconomics
Chapter # 1 & 2: Overview of Macroeconomics and
National Income
Hardwick P., Khan, B and Langmead, J (2006) Introduction to Modern
Economics. London, Longman.
Ahuja H., 2008. Macroeconomics; Theory and Policy advanced analysis.
Chand and company Ltd, New Delhi.
Teddy K. Funyina
School of Business: University of Lusaka
2016.
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1. Introduction to Macroeconomics
Economics can be defined as
I.
a social science that study how societies allocate scarce resources in an
attempt to meet the virtually limitless want of consumers
II. a social science that studies the production, distribution, and consumption
of goods and services
III. a social science that studies how individuals, governments, firms and
nations make choices on allocating scarce resources to satisfy their
unlimited wants
• The economic problem arises because individuals’ wants are virtually
unlimited, whilst the resources available to satisfy these wants are scarce.
• Economics can generally be broken down into:
a. Microeconomics
b. Macroeconomics
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2. Nature and Scope of Macroeconomics
• In ECF 100 we have studied microeconomics which is concerned with
analysing the behavior of individual households, firms or markets. It is
through their interaction that microeconomic theory explains how prices
of output and factors of productions are determined and how resources
are allocated between various outputs
• In microeconomic theory it is assumed that full employment of resources
such as labour and capital prevails and analyses how they are allocated
among different outputs. Further, it explains whether resource allocation
achieved is economically efficient.
• In this second volume we will study macroeconomic theory and its
application to the formulation of economic policies.
What is macroeconomics?
• Macroeconomics analyses the working of the national economy as whole
and its interaction with other economies
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• Macroeconomics is concerned with the analysis of the behavior of
economic systems in totality
• Thus, macroeconomics studies how the large aggregates such as national
output and employment, the general price level, total spending and saving
in the economy, total imports and exports and the demand for and supply
of money and other financial assets are determined.
• Macroeconomics deals with a number of large totals or aggregates which
are used to conceptualize and measure key components of the economy.
The most fundamental of these is the total output of goods and services,
conventionally referred to as the national income.
• Besides, macroeconomics explains how the productive capacity and
national income of the country increase overtime in the long run
2.1 The Origins of Macroeconomics “The Great Depression”
• In the late 1929, capitalist economies of the world experienced a severe
depression which created a lot of involuntary unemployment and also a
sharp fall in their GDP. This depression was caused by drastic decline in
private investment.
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• For instance, in the US, unemployment was estimated at 13 million people out of
the labour force of 51 million between 1929-1933. The similar problem prevailed
in Britain and other capitalist countries.
• This depression spurred a great deal of controversy among economists about the
causes of this depression and the policies to overcome it and restore full
employment.
• At this time a noted British economist J.M Keynes (1883-1949) challenged the
view of classical economists who applied microeconomic models to explain the
depression and involuntary unemployment.
• Keynes emphasized that the then prevailing depression and large scale
involuntary unemployment was due to lack of effective aggregate demand
resulting from a fall in private investment, he laid the foundation of modern
macroeconomics.
• Classical and neoclassical economists believed that the economy was at full
employment and that if there departures from full employment, a free market
economy would automatically work in a way that would restore full employment
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• They argued that involuntary unemployment and underutilization of productive
capacity could not occur in capitalist economies if market mechanism were
allowed to work freely without any interference. Thus, according to them, even
when deficiency of aggregate demand (AD) arises as it happens during the times
of recession or depression, prices and wages would change in such a way that
employment, output and national income would not decline.
2.2 Major Issues and Concerns of Macroeconomics
1. Employment and Unemployment
• The first major issue in macroeconomics is to explain what determines the level
of employment and national income in an economy and therefore what causes
involuntary unemployment.
• Why is the level of national income and employment very low in times of
depression as in the 1930s in various capitalist economies of the world
2. Determination of National Income (or GNP)
• National income is the value of all final goods and services produced in country in
a year.
• GNP shows the performance of the economy in a year and determines the overall
living standards of the people of a country. The higher the per capita national
income, the greater the amounts of goods and services available for consumption
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per individual on an average
3. General Price Level (Inflation)
• Another macroeconomic issue is to explain the problem of inflation. Inflation has
been a major problem faced by both the developed and developing countries in
past decades.
• Different arguments by the Classical and Keynesian economists have put forward
stressing the causes of inflation . The Classical economist argued that money
supply is always the cause of inflation whereas the Keynesians attributed
inflation to excessive aggregate demand.
4. Business Cycles
• Business cycles refer to fluctuations in output and employment with alternating
periods of boom and recession.
• In boom periods both output and employment are at high levels, whereas in
recession periods both output and employment fall and as a consequence large
unemployment come to exist in the economy.
• What are the causes of these business cycles or ups and downs in market
economies is an important macroeconomic issue which has been highly
controversial.
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Business Cycles ………….
CHAPTER 5 Introduction to Macroeconomics
 FIGURE 1. A Typical Business
Cycle
•
In this business cycle, the
economy is expanding as it
moves through point A from
the trough to the peak.
•
When the economy moves
from a peak down to a
trough, through point B, the
economy is in recession.
•
expansion or boom The period in
the business cycle from a trough up
to a peak during which output and
employment grow.
•
contraction, recession, or slump
The period in the business cycle
from a peak down to a trough
during
which
output
and
employment fall.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Macroeconomics 9e by Case, Fair and Oster
Business Cycles
Output Growth
Figure 2. U.S. Aggregate Output (Real GDP), 1900–2007
The periods of the Great Depression and World Wars I and II show the largest fluctuations in
aggregate output.
5. Economic Growth
• Another important issue in macroeconomics is to explain what determines
economic growth in a country.
• Economic growth means sustained increase in national income (GNP) or per
capita income over a sufficiently long period of time
6. Balance of Payments and Exchange Rate
• Balance of payment is the record of economic transactions of the residents of a
country with the rest of the world during a given period.
• The aim to prepare such a record is to present an account of all receipts on
account of goods exported, services rendered and capital received y the residents
of a country and the payments made for goods imported, services received and
capital transferred to other countries by residents of a country
• There may be a deficit or surplus in the balance of payment. Both create
problems for an economy.
• An important effect is that the transactions in balance of payment are influenced
by the exchange rate.
• The instability of the exchange rate has been a major problem in recent years
which has given rise to serious balance of payments problem.
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2.3 THE ROLE OF GOVERNMENT IN THE MACROECONOMY
• In modern macroeconomics, the intervention by government to influence
economic activity is well recognized. It is now widely believed that instability is
inherent in free market economy and further that there is no any self-correcting
mechanism to ensure stability at full employment level and sustained economic
growth.
• Government uses three (3) types of economic policies to influence the economy
1. Fiscal Policy
• An important way the government affects the economy is through the adoption
of appropriate fiscal policy
• The fiscal policy refers to taxation and expenditure decisions of the government
2. Monetary Policy
• Another important instrument which the government (through the Central Bank
of the country) uses to achieve the objectives of price stability, full-employment
and economic growth
• Monetary policy refers to the policies regarding growth of money supply,
availability of credit and interest or cost of credit.
• Monetary policy is an important tool of controlling inflation in the economy.
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3. Growth Policies
• Many economists doubt the efficacy of fiscal and monetary policies to eliminate
the fluctuations in the economic activity through demand management (that is,
influencing the level of aggregate demand).
• A school of economic thought known as the supply-side economics argues that
focus of government policy should shift from demand management to
stimulation of aggregate supply.
• For instance, in the 1970s when the US and Britain experienced the problem of
stagflation, some economists suggested that instead of demand management,
the government should reduce taxes to increase the incentive to work, save and
invest more. More labour supply and more investment will increase the supply of
goods and services. As a result, price will fall and at the same time output will
rise.
• The policies to reduce inflation through expansion in supply of output are
generally described as supply-side policies.
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3. CIRCULAR FLOW OF INCOME
• The circular flow shows how real resources and financial payments flow
between firms and households.
• The two main economic agents in the circular flow diagram are households and
firms. The households can be thought of as the owners of factors of production,
the services of which they sell to firms in exchange for income ( in the form of
wages, salaries, interest, rent and profits).
• Note that, in the model, all profits are assumed to be distributed to households
and not retained by the firms,
• The firms use the factors of production to produce the many different types of
goods and services they then sell to households (whose spending is called
consumption), government, foreign residents (who buy exports) and other
firms (whose spending on capital goods is called investment).
• The diagram also shows that the part of households income which is not spent
on consumption is either saved, spent on imports or is taken in taxes by the
government.
• The government uses its tax revenue (as well as money from other sources to
finance government spending, including transfer payments (such as pensions
and unemployment benefits).
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Figure 3,The Circular Flow
Wages, rents,
interest, profits
Factor services
Household
Goods
Government
Financial markets
Personal consumption
Other countries
Firms
(production)
• Before proceeding we must explain the terms consumption, saving, and
investment more fully.
• Consumption is the total expenditure by households on goods and services
which yield utility in the current period
• Investment is the production of, or expenditure by firms on, goods and services
which are not for current consumption: that is, real capital goods like factories,
machines, bridges and motorways, all goods which yield a flow of consumer
goods and services in future periods.
• Saving is that part of disposable income (that is, income less taxes) which is not
spent in the current period. It follows that disposable income minus saving
equals consumption.
• The circular flow of income suggests three ways to measure economic activity in
an economy:
1. The value of goods and services produced,
2. The level of factor earnings, which represents the value of factor services
supplied or services produced,
3. The value of spending on goods and services
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GDP and GNP
• Gross domestic product (GDP)
– measures the output produced by factors of production
located in the domestic economy
• Gross national product (GNP)
– measures the total income earned by domestic citizens,
regardless of where the output is produced
• GNP = GDP + net income from abroad
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4. THREE MEASURES OF NATIONAL OUTPUT
• The three (3) ways of measuring the annual value of total output in an economy
are by calculating its national product, national expenditure and national income.
We consider these in turn.
1. National Product (Y= Q*P)
• This is found by adding up the value of all final goods and services produced by
firms during the year.
• Note that all final goods and services produced must be included, whether they are
to be sold abroad as exports, or whether they are capital goods to be sold to other
firms.
• It is, however, important to include only final goods and services: all intermediate
goods must be excluded so that double-counting is avoided.
• For instance, in the production of bread, only the value of final bread should
counted. The value of wheat grains and flour are included in the value of bread. If
we were to count them as well, we should be guilty of double- or even triplecounting. If all intermediate goods were included in the calculation of national
product, thus, we would seriously overestimate the value of the country’s total
output
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• One way of avoiding double-counting is to sum the values-added by all firms at
the different stages of production. To illustrate this, consider a simple example
in which producing a loaf of bread involves the following three stages of
production:
1. A farmer produces wheat grains and sells it to a miller for K10. This
represents an income of K10 for the farmer. Value-added=K10
2. The miller uses the wheat grain to produce flour which it sells to a bakery for
K21. This represents income (including profit) of K11 for the millerremember that K10 has had to be paid for the wheat grain. Value-added=
K11.
3. The bakery produces bread and sells it for K40. This includes K21 to cover
the cost of flour and K19 to pay incomes , including profits. Valueadded=K19.
• The total value –added in this example (K40) is just equal to the value of the
final bread.
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2. National Expenditure (Y= C+ G+ I+ (X-M))
• This is found by adding up all the spending on the final goods and services
produced by firms.
• Such an aggregate will only equal the value of total output if those goods which
are produced but not sold are also included- this item, which is called ‘net
changes in stocks and work in progress’, is normally counted as part of firms’
investment spending (which is logical since such goods are for future rather than
current consumption).
• National expenditure, then, is the sum of consumption of domestically produced
goods, investment (including changes in stocks and work in progress),
government expenditure and exports.
• Notice that, as before, in order to avoid double-counting, only spending on final
goods and services is included.
3. National Income
• Another way of calculating the value of total output is to add up all the incomes
(that is, wages, salaries, rent, interest and profits) of all factors of production,
those producing intermediate goods as well as those producing final goods.
• It is important in using this method to exclude all transfer payments as these
present nothing more than the redistribution of income from taxpayers to
transfer recipients; including them, thus, would involve double counting.
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• Assuming : (a) that all three measures are calculated accurately; (b)that only final
goods and services are counted in the national product and national expenditure
figures (c) that any changes in unsold stocks are included in the national
expenditure figures; and (d) that all incomes, including profits but excluding
transfer payments, are counted in the national income figures, then it must follow
that all three(3) measures will provide an identical figure for the value of the
country’s total output. That is,
• National Product≡ National Expenditure≡ National Income,
• where ≡ means ‘is identical to by definition’. In principle, then, these three simply
represent different ways of measuring the flow of output or income being created
in an economy over a period of time.
4.1 COMPLICATIONS FACED WHEN CALCULATING TOTAL OUTPUT
1. Depreciation – When investment takes place, new capital is created and it is
correct that this should be included in our calculation of the value of total output
for that year.
• Some investment occurs, simply to replace capital which has worn out during the
year – such ‘wearing out’ of capital is called depreciation or capital consumption.
Where no allowance is made for this depreciation in the calculation of investment,
the resulting figure is called gross investment.
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• When depreciation is deducted from gross investment, we have net investment
and it is this which measures the true addition to the country’s capital stock
during the year. Where no allowance is made for depreciation in calculating the
value of total output, the resulting figures are also referred to as gross. Thus, we
have:
• Gross national product
Net national product
Gross national expenditure - depreciation =
Net national expenditure
Gross national income
Net national income
• Economist are usually quite happy to with gross rather than net figures because
I.
depreciation tends to change only slowly over time so that the gross and net
figures move closely together over any period of a few years,
II. depreciation figures are notoriously difficult to estimate with any accuracy.
2. Stock appreciation – We have noted that all three measurements of total output
include the value of the net change in stocks of unsold goods. If prices are rising,
the value of firms’ stocks will be rising even if there are no net physical additions to
them. To take account of this so-called ‘stock appreciation’ , it is necessary to
subtract an appropriate amount in computing the national income.
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3. Market prices and factor cost
• When national expenditure is computed, it is measured initially in market prices
– for example, the total spending on beer is equal to the quantity of beer bought
times its average market price. Unfortunately, many market prices are distorted
by indirect taxes and subsidies: indirect taxes have the effect of raising the prices
of goods above what would otherwise have been set, while subsidies lower such
prices.
• National income and national product, however, are both measured at factor
cost – that is, in terms of the sums paid out to the owners of factors of
production – and this excludes indirect taxes and subsidies. To ensure that
national expenditure is the same as national income and national product, it is
necessary to convert market prices to factor cost by subtracting indirect taxes
and adding subsidies. In other words, we can write:
NE at market prices – Indirect taxes + Subsidies = NE at factor cost
4. Net property income from abroad
• Some of the output produced within Zambia is actually produced by firms which
are owned by overseas residents. Similarly, some output produced overseas is
produced by firms owned by Zambian residents or companies.
• Whether this should be taken into account or not in calculating the value of total
output depends on whether we require a measurement of the GDP or GNP.
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• In the former case, we need make no adjustment but the figures are renamed
domestic product , income and expenditure. In the latter case, net property
income from abroad has to be added, where the term net property income
from abroad is equal to that income received by Zambian residents from the
production of output by firms overseas minus that income paid to overseas
residents from the production of output by domestic firms.
• Gross domestic product
Net property
Gross domestic income
+ income from
Gross domestic expenditure
abroad
=
Gross national product
Gross national income
Gross national expenditure
4.2 The Black Economy
• It should be pointed out that official statistics tend to underestimate the actual
volume of economic activity that occurs. This is because of the so called ‘black’
or underground economy. The black economy refers to those unrecorded
economic transactions conducted on a cash basis with a view to illegal evasion of
tax.
• Evidence for 2006 suggested that the black economy in the UK and Italy
amounted to about 14.5% and 30% of national income.
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National income accounts
Gross and National Expenditure for UK, 1996 ( In million Pounds)
Consumers' expenditure
473,509.00
General government final consumption
155,732.00
Gross domestic fixed capital formation
114,623.00
Value of physical increase in stocks and work in progress
2,917.00
Total domestic expenditure at market prices
746,781.00
Exports of goods and services
217,147.00
Imports of goods and services
(222,603.00)
Taxes on expenditure
(108,484.00)
Subsidies
Statistical discrepancy
Gross domestic expenditure at factor cost
Net property income from abroad
9,100.00
975.00
642,916.00
9,652.00
Gross national expenditure
652,568.00
Depreciation
(77,372.00)
Net national expenditure
575,196.00
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KEY ACCOUNTING IDENTIES
• Y ≡ C+ I+ G+ (X – M)………….. (1)
• where all variables are measured at factor cost and ‘I’ is defined to include not
only expenditure on capital goods but also any net changes in stocks of unsold
goods and work in progress
• When the national income is received by households, it will either be spent on
consumption, saved or be paid out in taxes. Thus, we can write:
• Y ≡ C+ S+ T ……………………………..… (2)
• where S represent household savings and T represents net taxation (that is ,
direct taxes less transfer payments. Indirect taxes and subsidies have already
been accounted for by measuring expenditure at factor cost. Identities (1) and
(2) together mean that:
• C+ I+ G+ (X – M) ≡ C+ S+ T , from this , we can write:
• I+ G+ (X-M) ≡ S+ T or
• (S – I) + (T – G) ≡ (X – M)…………………(3)
• (S – I) represents the net savings of the private sector
• (S – I) > 0, the private sector is said to have a financial surplus
• (S – I) < 0, the private sector is said to have a financial deficit
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•
•
•
•
•
(T – G) > 0, the public sector is said to have a surplus
(T – G) < 0, the public sector is said to have a deficit
(X – M) > 0, the country has a current account surplus
(X – M) < 0, the country has a current account deficit
From (3), we see that net saving by the private and public sectors would imply
a current account surplus
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4.2 National Income and Economic Welfare
 Economic welfare implies the general level of well-being in a society which
depends on such factors as the quantity of goods and services available, the
distribution of income, the impact of externalities and the composition of
output.
 Since the national income of a country is a measurement of the output of the
final goods and services produced by that country in year, we cannot conclude
that if national income rises from one to the next, economic welfare must also
rise, unless we first convert national income into real national income per capita.
 To convert national income into real output per capita, it is necessary to make
two adjustments
1. National income must be deflated by an appropriate price index to convert to it
to real terms
2. The figure must then be divided by the population to convert it to per capita
terms
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• To show how these adjustments are made, consider a simple numerical
example. Table below shows two years 1995 and 1999 being compared for a
hypothetical economy.
• Notice that money national income has increased by 100% during the period,
but prices have risen by 20% from the base-year figure of 100 in 1995 to 120 in
1999, and population has risen by 33.33% from 3,000 to 4,000.
• The first step is to deflate the national income figures to eliminate the effects
of the rise in prices. As 1995 is the base year, the money value and the real
value of national income are the same in that year.
• In 1999, though, the price index is 120 and this means that part of the increase
in national income is a result of the rise in prices rather than the rise in
physical output.
1995
1999
National income
$12m
$24m
Price index
100
120
Real national income
(1995 prices)
$12m
$20m
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 The rise in prices is eliminated from the figures by dividing national income by
the price index and multiplying by 100. This calculation is called deflating the
national income. Comparing the deflated figures, we see that real national
income (or national income in constant prices) has increased by 66.67% from
$12 million to $20 million during the period.
 The next step is to take into account of the increased size of population
because, although real national income has risen, it has to be shared out
among more people.
 Dividing the real national income figures by population for two years, we
obtain a figure for ‘real output per capita’ of $4,000 and $5,000 in 1995 and
1999 respectively, an increase of 25%.
 In this example, although money national income rose by 100%, real output
per capita rose by only 25%.
 We can conclude that an increase in national income will only be equivalent
to the same proportionate increase in real output per capita if both prices
and the population remain unchanged.
 Since prices and population generally change overtime, it is crucially
important to compare real output per capita figures than money national
income figures before coming to any conclusions about changes in economic
welfare.
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Merits and Uses of National Income Statistics
1.Reflecting & comparing the standards of living of different countries per capita
real GNP  standard of living
2. Providing information to the government and firms for economic planning
3. Reflecting the economic growth of a country % change in real GNP over a period
of time
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Limitations of the GDP Concept
1. Society is better off when crime decreases; however, a decrease in crime is
not reflected in GDP.
2. An increase in leisure is an increase in social welfare, but not counted in
GDP.
3.Most nonmarket and domestic activities, such as housework and child care,
are not counted in GDP even though they amount to real production.
4. Black economy. The part of the economy in which transactions take place
and in which income is generated that is unreported and therefore not
counted in GDP.
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Human Development Index (HDI)
 Is GDP a good indicator of the standard of living of a country?
 Isn't it too narrow to only look at the output of a country?
 The United Nation developed an index called Human Development Index
(HDI) that gathers information about:
1. education
2. life expectancy (proxy for health)
3. GDP per capita
• It is a index between 0 and 1.
• It is a weighted average of the 3 components: broader measure, better
assessment of human well-being.
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P (2006)
P (2007)
Wheat
4
5
Cloth
12
16
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