LESSON 2:

APPROACHES OF MACRO ECONOMICS and

MODELS OF CIRCULAR FLOW OF INCOME
Objectives:
After studying this lesson, you will be able to understand

• Different economic approaches in an economy

• Various macro economic variables in an economy

• The definition of Circular flow of income and expenditure

• The distinction between money and physical flows

• The Circular flow of income and expenditure under different sector models

• The importance of circular flows under different sector models

2.1 Introduction

2.2.1 Economic Approaches

2.2.2 Macro Economic Variables

2.2.3 Circular flow of Income and Expenditure in Two Sector Model

2.2.4 Circular flow of Income and Expenditure in Three Sector Model

2.2.5 Circular flow of Income and Expenditure in Four Sector Model

2.3 Summary

2.4 Check your Progress

2.5 Key Concepts

2.6 Self Assessment Questions

2.7 Answers to check your progress

2.8 Suggested Readings

2.1 Introduction:

Macroeconomics is the study of economic system as a whole. It covers not individual

units but of all the units taken together, thus macroeconomics became the study in
aggregates and is often called ‘Aggregative Economics’. Mainly it deals with the theory
of income, Employment, Prices and money. The Great depression (1929-32) and un-
employment are the two main causes are led to the emergence of macroeconomics as an
important area. JM Keynes became the chief advocate of macroeconomics by brought out
the general theory in 1936. In fact, this book may well be described as ‘Aggregative
Economics’ Many economists had contributed a lot to strengthen the subject, like, L
Walrus, K Wick sell and I Fisher in desire to control business cycles contribute their mite
towards the development of macro economic studies.

Professor Boulding says “ Macro economics, is that part of the subject which deals with
aggregates and averages of the system rather than with particular items in it and attempts
to define these aggregates in a useful manner and to examine their relationship”

As stated earlier, macro economics deals with several aspects related the whole economy,
like how the level of income and employment determined, how the general price level
determined, how consumption, Investment and Liquidity preference functions conceived
in aggregate terms etc., We have explained in brief all aspects of macro economic
theory. These aspects are shown in the following chart.

Macro economic theory

|
---------------------------------------------------------------------------------
Theory of Income & Theory of General Price Level Theory of Economic Growth
Employment & Inflation
|
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Theory of consumption |
Function Theory of Investment
| |
----------------------------------------------
|
Theory of Fluctuations (Business Cycles)

2.2.1 Macro economic approach:

There are two methods of approach to the study of economic theory, one may start with
the study of individual units and then may shift from individual units to aggregates by
summing up the various individual conclusions. It is known as “Micro approach”. But it
has its own limitations. Basically, in the computation, say of total agricultural production
or total national income, it is very tough to obtain correct figures of production or income
of all production units or individuals. It involves a lot of guesswork and a good amount of
uncertainty. Even in the matters of analysis, it may be found that what is true of single
individual may not be true of the whole community. On the theoretical level, it is again
true that what may be relevant in a specific instance is not true at the level of aggregates.
If we assume the economy as a whole to be only one big firm, there may be no need to
study or to develop the theories of macroeconomic behaviour. “But macroeconomics is
set apart as a separate discipline with its own rules because aggregate economic
behaviour does not correspond to the summation of individual activities”. This can be
identified with “Macro approach”. To understand this fully, few examples may be useful.
An individual may become rich by finding a few currency notes but no country will
become rich by printing few more notes. Further, one man by wiillingness to work for
less may overcome his own unemployment, but the general unemployment problem
cannot be solved in this way. Again, wage cutting in a particular firm may promote
employment, but the general wage cutting in the economy as a whole may actually
diminish the volume of employment. Thus, what is prudent behaviour for an individual or
single business firm may at times be a folly for a nation or a state. Examples could be
multiplied. Most of these cases, which seem paradoxical at first, stem from the fact that
what is true for an individual, are true only if other things remain equal. It is a legitimate
assumption in microeconomic analysis. In macroeconomics, however, such a
presumption is not justified; therefore, quite a different approach to the analysis of
macroeconomic problems must be developed. Professor Samuelson calls above instances
the ‘fallacy’ of composition and prof. Boulding call them’ Macroeconomic Paradoxes’.
“Macroeconomic Paradoxes” according to Prof Boudling, “are those propositions which
are true when applied to a single individual but which are untrue when applied to the
economic system as a whole”. There is little scope for the blind application of
conclusions regarding individuals to the economic system as a whole, therefore, great
action and care is needed for the application of microeconomic conclusions to the field of
macroeconomics. Hence, there is a perfect justification for evolving and developing
macroeconomics as a separate branch of economics analysis.

Another method of approach consist in the direct study of macroeconomics by passing at

the same time the study of individual units and directing the investigations with reference
to the economy as whole. This method, too, has its limitations. It studies the economy as
a whole while ignoring the individual units, for what holds true of the economy as a
whole may not be so in the case of individual units: for example, a study of the
aggregates may lead us to conclusion that no change is needed in the general price level,
as with a fall in agricultural prices in the economy, other prices may have risen and the
two offset each other but in reality steps may have to be taken to stabilize agricultural
prices.

Actually, no hard and fast line of demarcation can be drawn between macroeconomic and
microeconomic theory. Neither approach by itself is complete without the other. As a
matter of fact, no serious student of economic analysis can help studying both the
approaches in an unbiased manner. Both micro and macro approaches are needed for
complete understanding and solution of economic problems. What particular approach
will be best suited for a scientific understands of a given economic situation depends on
the object we have in mind. Professor Samuelson rightly says that really no opposition
between micro and macroeconomics. Both are absolutely vital. And you are only half
educated if understand the one while being ignorant of the other”.

2.2.2 Macro economic variables:

Macro economic analysis is depends upon a large number of variables or concepts, terms
and instruments. Macro economic problems can be easily grasp by understanding these
terms and instruments. We explain not all variables but only a few of them, which are
more important and prominent in the aggregative analysis.

Variables:

A magnitude that changes over a given period of time can be called a variable. For
instance, different levels of incomes, employment and prices. The variables can be
classified as follows:

a) Stock & Flow Variables

b) Endogenous & Exogenous variables
c) Dependent & Independent variables

Other terms/devices discussed here are:

a) functional relationships and parameters
b) Time-Series and Cross-Section data
c) Ex-ante and Ex-Post
d) Identities and Equations
e) Equilibrium
f) Lag
g) Economic Models

Stock & Flow Variables

A stock variable is one, which has no time dimension but is described at a specific
moment of time. A flow variable, on the other hand, involves of necessity a time
dimension and it is always expressed per unit of time, say a day, a month or a year.
Consider, for instance a lake fed by a single stream. The volume of water contained in the
lake at a given point of times is a stock; the volume of water flowing into it over some
period is a flow.

In brief, stock variables are measured at a moment f time and have meaning
independently of any period. Flow variables are defined necessarily with reference to a
period of time and can be measured and given meaning only in terms of this time period.

Endogenous and Exogenous variables:

the variables, which are internal to the economic system and constitute an integral part of
the system, are knowing as endogenous variables. For example, levels of income, output
and magnitudes of saving and investment, or demand and supply, etc are essentially the
variables which internal to the economic system. But the variables like growth and
composition of population, imports, innovations etc may be regarded as the exogenous
variables.

Dependent and Independent variables:

A variable is said to be a dependent variable, when its magnitude is related in some

unique way with the changes in the magnitude of some other variable. For instance,
demand varies inversely with price, if other things remain the same. In this case demand
depends upon price of a commodity, therefore, the former is the dependent variabel while
the latter is the independent variable.

Functional relationships and Parameters:

A functional relationship among two or more variables implies that there is some unique
relationship between their magnitudes such that change in the magnitude of one variable
is associated in some regular and definite way with the change in another variable. The
functional relations may be expressed as: C=f (Y); here ‘C’ consumption, and ‘Q’ Output
are the functions of income (Y). These relationships imply that consumption depends
upon income. And the variables, which in a functional relation, are assumed to be
constant, are called the Parameters. Ex: C = f (Y,P,M,W) P,M and W are assumed to be
constant and as such these are the parameters and C and Y are respectively the dependent
and independent variables.

Time Series and Cross-Section Analysis:

if the data concerning a particular variable are obtained from a specific entity
continuously period after period say years, months they constitutes a time series. The
cross-sectional analysis is based on the data obtained from the different sub-divisions or
cross-sections of the society at the same time.

Ex-ante and Ex-Post:

Ex-ante and ex-post are the Latin terms meaning ‘beforehand’ and ‘afterwards’
respectively. The Swedish School of thought prominently introduced the terms in
economic literature. Ex-ante variables like savings, investment refers to their estimates at
the beginning of a specific period. Thus, in the ex-ante sense, these variables are in the
planned, desired. The amount of savings, investment, and income, production in the ex-
post sense mean the actual magnitudes of these variables at the end of a specific period.
Thus, in the ex-post sense, these variables are actual, realised or observed.
Identities and Equations:

A relationship, which is assumed to be true by its definition, is said to be an accounting

relationship or an identity. For example, saving may be defined as an excess of income
over consumption. Similarly income may be defined as their sum of consumption and
investment. Whatever the magnitude of the variables involved, given the above
definitional relationships there must be an identity between saving and investment.

S = Y-C and Y=C+I therefore: S = I

The behavioural relationships may be expressed in the form of equations and may be
denoted by the symbol ‘=’ . For example;

C = Co + bY

Thus the distinction between identities and equations points to the fact that the identities
hold whatever the magnitudes of the variables and cannot be tested by empirical
investigations. The behaviour relations or equations, on the opposite are the propositions
about eh economic behaviours, which can be tested by empirical observations either
directly or via predictions derived from them.

Equilibrium:

Equilibrium implies such magnitudes of the variables, which do not permit any departure
of the economic system from a specific position. In the words of Gardener Ackley: ‘ A
system can be said to be in equilibrium when all of its significant t variables show no

change, and when there are no pressures or forces for change which will produce
subsequent change in the values of the significant variables.’

Lag:

The macro economic problems have been analysed either in terms of instantaneous
adjustments or the lagged adjustments. In the study of continuous adjustments, the rates
of change of the variables are in such normal or equilibrium relations that the adjustments
take place instantaneously and the equilibrium is never disturbed. In the period analysis,
the different economic variables pertain to different time period, as the magnitude of one
of the variable changes, the equilibrium gets disturbed. Some time interval must elapse
before a harmonious adjustment takes place among the different variables, the time
interval required for adjustments is called as time lag.

Economic Model:
An economic model consists simply of a group or set of economic relationships each one
of which involves at least one variable that also appears in at least one other relationships
which is part of model. Koopmans considers a model to be a set of structures.

In our previous section, we discussed the important macro economic variables and
economic approaches at length. The objective of the present chapter is to study the
circular flow of income and expenditure in an economy. Circular flow of money means
that” the money spent must not be hoarded and should continue to flow to maintain a
certain level of economic activity”. In the process of economic development, various
economic activities among the different sectors is takes place, while performing
activities, money flows between the different sectors in the form of payments and
receipts. These receipts and payments are in both the financial and physical forms.
Therefore, in this lesson, our concentration is on, how the income flows among the
different sectors of an economy. These flows are discussed under different sectors such as
flows between two sectors, three sectors and four sectors. .

2.2.3 Circular flow of income & expenditure in two-sector model:

In the two-sector model, the circular flow of income & expenditure refers to the process
whereby the national income and expenditure of an economy flow in a circular manner
continuously between two sectors through time. The important activities are by
household sector are sale of its labour for production in the product market to business
sector, and purchase of goods and services produced by the business sector in turn,
household sector receives the wages as remuneration for rendered its services. On the
other hand household sector pay the amount for consuming goods and services to
business sector. In this process, both the sale of labour by house hold sector and purchase
of goods and services by household sector are became a physical flows and payment of
wages to labour by business sector and amount paid for purchases by household sector to

business sector, are became money flows. Now let us see there flows which are
presented in the fig 1.1 where the business sector which produces goods and services is
shown in the upper portion and the household which owns all factors of production in the
lower portion. From the business sector, household sector purchases goods and services
in the product market and pay the amount, while the household sector, receives income
from business sector for the services rendered by the household sector to business sector.
Thus, payments go around in a circular manner from business sector to household sector
and back as shown by arrow marks in the outer portion of the figure.

Fig 1.1 Circular flow in Two Sector Model

|---<---<- Consumption Expenditure<-- |

| |
| | -- Product Market ->->->--------|
Business HouseHold
 Sector Sector
| |---<----< Factor Market--<-------------|
| |
| ------ Income Payments ------------|

Further, the circular flow of income and expenditure with savings and investment gives
different information. It means that, in an economy, inflows and outflows occur in the
expenditure and income flows. Below figures shows how the circular flow of income and
expenditure is changed by the inclusion of investment and saving. In this form of system,
the household sector provides saving to the capital market. Therefore, the amount
supplied in the form of savings by household sector reaches to capital market, in turn
capital market invest the savings amount to business sector.

2.2.4 Circular flow of Income and expenditure in three sector model:

If we add the government sector to the two sector closed model, it became three-sector
model of circular flow of income and expenditure. Government sector role in an economy
is to collect the taxes and purchase of the goods and services. First one is a leakage or
outflow from the circular flow and the second one is inflow/injection into the circular
flow. The taxes imposed by the government sector are in the form of personal income
tax, commodity tax paid by the household sector is considered as a leakage while the
purchase of goods and services are injections to circular flow. In addition to purchases,
transfer payments, unemployment relief, sickness benefits etc., are all expenditure by the
Government al also inflows into the circular flow. Similarly, if we take the transactions
between government sector and business sector, business sector pay taxes to government
sector, which is leakage from circular flow and government purchases from business
sector, subsidies etc., are the inflows into the circular flow. We shown the inflows and
outflows in the circular flow by including all three sectors i.e. house hold sector, business
sector and government sector together in the fig 1.2

It is clear from the figure that taxes flow out from the household sector and business
sector to the government and investment flow out from government to household and
business sector. If government purchases exceeds net taxes, then the government finances
the deficit by borrowing from the capital market which receives funds from household
sector, instead, if government purchases are less than the taxes, it reduces the public debt
and supplies funds to the capital market

2.2.5 Circular flow of income and expenditure in a Four-sector model:

So far we have been working on the circular flow of income and expenditure of a three
sector closed model. To this we add the foreign sector to make it a four-sector model.
Infact, the actual economy in an open economy where foreign trade plays an important
role. Foreign trade refers the exports and imports, in which exports to foreign is an inflow
and imports for foreign is an outflow from the circular flow. This sort of exports and
imports in circular flows are shown in fig 1.2
Now let us see the inflows and outflows of these three sectors in relation to fourth sector.
The households purchase the imported goods and service and, it receives the transfer
payments from the foreign sector for the services rendered by them in foreign. So first
one is leakage and the second one is inflow into the circular flow. On the other hand, the
business sector exports the goods and services to foreign and import the goods and
services from foreign sector. For which business sector receives and also pay the money.
These activities also lead to injections and leakages respectively. Like the business sector,
government sector also export and import and lend to and borrow from foreign sector.
Similarly, foreign sector also export and import goods and services for which business
sector, government sector and household sectors receives payments from foreign sector.
Further, government sector also receives royalties, interest, dividends etc., for investment
made abroad. All the types of above transactions are shown in fig 1.3

If exports are exceeds the imports, the economy has a surplus in the balance of payments
and if imports exceed exports it has deficit in balance of payments. But in this long run
with its trade policies government tries to make balance exports with imports.

Importance of circular flow of income and expenditure:

The Circular flow of income and expenditure highlights the importance of both the fiscal
and monetary policies. The importance of monetary policy in circular flow of income and
expenditure is observed when savings exceeds investment or investment exceeds savings.
It means that the disequilibria in savings and investment set by following credit and
monetary policies. Similarly, if savings and taxes amount exceeds the investment and
government spending amount should adopt such fiscal measures as reduction in taxes and
spending more itself. Therefore, with the help of circular flow of income and expenditure
the problem of disequilibria and the restoration of equilibrium can be observed.

2.3 Summary:
Macro economic theory is the theory of Income, Employment, prices and money.
Macroeconomics is the study of economic system as a whole. It covers not individual
units but of all the units taken together, thus macroeconomics became the study in
aggregates and is often called ‘Aggregative Economics’. Though there are two different
approaches, but no hard and fast line of demarcation can be drawn between
macroeconomic and microeconomic theory. Neither approach by itself is complete
without the other. The Circular flow of income and expenditure is a simplification of
which attempts to illustrate the flow of money and goods from households to business
and back to household sector. The circular flow of economic activities is maintained not
only in two sectors but also in three sectors and four sectors. The circular flow of income
and expenditure explains how the leakages and injections are destabilising the economy.
Further, it also recommends the policy and suitable measure to be adopted to restore the
equilibrium in the system. We can know whether the economy is working efficiently or
whether there is any disturbance in its smooth functioning.
2.4 Check your Progress

State whether the following statements are true or false?

a) Te Time Interval required for adjustments is called as lag

b) Koopmen considers a model to be a individual structure
c) Equilibrium implies a imperfection in all the plans
d) Stock variables are measured at a moment of time
e) Government sector is a part of two sector circular flow of income model
f) Widow pension consider as a transfer payments

2.5 Key Concepts

a) Macro economic approach
b) Stock and flow variables
c) Exogenous and Endogenous variables
d) Ex-ante and Ex-post
e) Identities and Equations
f) Closed economy
g) Physical flows
h) Money flows
i) Net domestic product
j) Net factor Income

2.6 Self Assessment Questions

Short Note Questions:

a) what is macroeconomics?
b) Give a clear exposition of an economic model?

c) Write a note on the following:

i) Stock and flow variables
ii) Time series and cross section data

Essay type Questions:

a) Distinguish between Micro and Macro approaches?

b) What is the difference between functional relationship and parameters?
c) Explain the Circular flow of income in a two sector system?
d) Discuss the circular flow of income in a four sector system?
2.7 Answers to check your Progress

a) True b) False c) False d) True e) False f) True

2.8 Suggested Readings

Ackley, Gardner: Macroeconomic Theory
Shapiro E: Macroeconomic Analysis
Diulio E A: Macroeconomic theory
Paul Samuelson: Economics