Macroeconimics

What is 'macroeconomics'?

You may have already studied microeconomics, which

looks at supply, demand and prices for individual

goods. Macroeconomics looks at the bigger picture

and involves the study of the economy as a whole.

National income

Let us start by looking at a simple example - a

'two sector' economy made up of households

(consumers) and firms (producers) -and use this to

develop the idea of national income. To start with

we will ignore the impact of government policy and

overseas sectors.

Households ultimately own the factors of

production, e.g., labour, materials and capital,

and supply these factors to firms who use them to

produce goods and services. In return households

earn rewards for supplying the firms with the

factors of production e.g., wages and interest on

capital. These rewards are in turn used to buy the

goods that the firms have produced. This process

is known as a circular flow- see Figure 1.

Figure 1: Simple circular flow

From Figure 1 we can see that there are three ways

of measuring the amount of economic activity in

the economy. These are:

(a)National product/output = the flow counted at

this point represents the amount received by firms

for their total production.

(b) National income = the flow counted at this

point represents the total income received in

return for factors of production.

(c) National expenditure = the flow counted at

this point represents the total expenditure by

households on goods and services.

If it is assumed that all income is spent, then

whichever method is used the same measure of

economic activity must be obtained. Let's look at

a numerical illustration.

Illustration

Assume there are two producers - a lumberjack and

a carpenter. The carpenter makes chairs each of

which needs Ј5 worth of wood and which he sells

for Ј20. Total annual sales are 10,000 chairs. The

income and expenditure accounts for the lumberjack

and carpenter are:

CarpenterЈ000LumberjackЈ000

Purchases (wood)50

Wages40Wages10

Interest20Interest5

Rent50Rent20

Profit40Profit15

Sales200Sales50

'National Product' = 200

This is the total value of the production (i.e.,

chairs)

'National Income' = 40 + 20 + 50 + 40 + 10 + 5 +

20 + 15 = 200

This is the total received for factors of

production i.e., wages, interest, rent and profit

'National Expenditure' = 200

This is the total amount spent on production (i.e.

chairs).

We can see that the three measures of economic

activity all give the same value.

Now we can start adding to this model to make it

more realistic. This model will use the following

definitions:

Consumption (C) - consumption goods produced and

sold to customers i.e., the chairs.

Savings (S) - income that is not spent on

consumption.

Investment (I) - production of, or expenditure

on, non-consumption goods (carried out by firms)

including expenditure on increasing stocks of

consumption goods.

Injections - expenditure on domestic output not

originating from consumers e.g., investment.

Leakages - income not spent on consumption of

domestic output e.g., savings.

Consumers will not spend all their income on goods

and services. They will also have savings - income

not spent on consumption. Similarly producers will

not just spend on producing goods but will also

carry out investment - expenditure on

non-consumption goods.

There are therefore injections into (investment)

and leakages from (savings) the circular flow.

These injections and leakages can now be added to

the circular flow model (see Figure 2)

Figure 2

Notes to Figure