MACROECONOMICS

Components Of Macroeconomics

The four macroeconomic sectors are often delineated by who or what is included.
Consider each sector.

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

breathing, consuming population of the economy. In a word, it includes everyone, all
consumers, all people, and every member of society. Pollyanna Pumpernickel, a hardworking
mother of two, is a representative member of the household sector. So too is Winston Smythe
Kennsington III, an affluent corporate executive.

Business Sector: This sector contains the private, profit-seeking firms in the economy
that combine scarce resources into the production of wants-and-needs satisfying goods and
services. It includes proprietorships, partnerships, and corporations. OmniConglomerate, Inc.,
a multi-billion dollar, multi-national, mega corporation, exemplifies a member of the business
sector. However, Manny Mustard, a proprietor who owns and operates a little sandwich shop
is also part of the business sector.

Government Sector: This sector includes all government entities that impose resource
allocation decisions, that might not be made otherwise, on the rest of the economy. It consists
of the three primary levels of federal, state, and local government responsible for passing and
enforcing laws. Of course, all branches and agencies of the U.S. Federal Government--
Congress, Department of Transportation, Environmental Protection Agency, etc.--is part of
the government sector. So too is the Shady Valley City Council and the local Shady Valley
Board of Education included in the government sector.

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. The foreign sector of the domestic United States economy
includes the governments of other nations such as the Republic of Northwest Queoldiolia. It
also includes citizens and businesses in other nations, such as Horst Duncanstein, a citizen of
Northwest Queoldiolia, and Quedoldiolian Sundial Company, also located in Northwest
Queoldiolia.
The Circular Flow

Introduction to the Circular Flow of Economic Activity:

The all pervasive economic problem is that of scarcity which is solved by three institutions
(or decision-making agents) of an economy. They are households (or individuals), firms and
government. They are actively engaged in three economic activities of production,
consumption and exchange of goods and services. These decision-makers act and react in
such a manner that all economic activities move in a circular flow.

First, we discuss their nature and role in decision-making.

Households:
Households are consumers. They may be single-individuals or group of consumers taking a
joint decision regarding consumption. They may also be families. Their ultimate aim is to
satisfy the wants of their members with their limited budgets.

Households are the owners of factors of production—land, labour, capital and entrepreneurial
ability. They sell the services of these factors and receive income in return in the form of rent,
wages, and interest and profit respectively.

Firms:
The term firm is used interchangeably with the term producer in economics. The decision to
manufacture goods and services is taken by a firm. For this purpose, it employs factors of
production and makes payments to their owners. Just as household’s consumer goods and
services to satisfy their wants, similarly firms produce goods and services to make a profit.

The term ‘firm’ includes joint stock companies like DCM, TISCO etc., public enterprises like
IOC, STC, etc., partnership concerns, cooperative societies, and even small and big trading
shops which do not manufacture the commodities they sell.

Government:
The government plays a key role in all types of economic systems—capitalist, socialist and
mixed. In a capitalist economy, the government does not interfere. It simply establishes and
protects property rights. It sets standards for weights and measures, and the monetary system.

In a socialist economy, the role of the government is very extensive. It owns and regulates the
entire production and consumption processes of the economy, and fixes prices of goods and
services. In a mixed economy, the government strengthens the market system.
It removes its defects by regulating the activities of the private sector and by providing
incentives to it. The government also uses resources to produce goods and services itself
which are sold to households and firms. These decision-making agents take economic
decisions to produce goods and services and to exchange them in order to consume them for
satisfying the wants of the whole economy.

Production, consumption and exchange are the three main activities of the economy.
Consumption and production are flows which operate simultaneously and are interrelated and
interdependent. Production leads to consumption and consumption necessitates production.

In other words, production is a means (beginning) and consumption is the end of all
economic activities. Both production and consumption, in turn, depend upon exchange. Thus
these two flows are interrelated and interdependent through exchange.
Aggregate Demand–Aggregate Supply

A traditional AS–AD diagram showing a shift in AD and the AS curve becoming

inelastic beyond potential output. The AD-AS model has become the standard textbook
model for explaining the macroeconomy. This model shows the price level and level of real
output given the equilibrium in aggregate demand and aggregate supply. The aggregate
demand curve's downward slope means that more output is demanded at lower price
levels.The downward slope is the result of three effects: the Pigou or real balance effect,
which states that as real prices fall, real wealth increases, resulting in higher consumer
demand of goods; the Keynes or interest rate effect, which states that as prices fall, the
demand for money decreases, causing interest rates to decline and borrowing for investment
and consumption to increase; and the net export effect, which states that as prices rise,
domestic goods become comparatively more expensive to foreign consumers, leading to a
decline in exports.

In the conventional Keynesian use of the AS-AD model, the aggregate supply curve is
horizontal at low levels of output and becomes inelastic near the point of potential output,
which corresponds with full employment.Since the economy cannot produce beyond the
potential output, any AD expansion will lead to higher price levels instead of higher output.
The AD–AS diagram can model a variety of macroeconomic phenomena, including inflation.
Changes in the non-price level factors or determinants cause changes in aggregate demand
and shifts of the entire aggregate demand (AD) curve. When demand for goods exceeds
supply there is an inflationary gap where demand-pull inflation occurs and the AD curve
shifts upward to a higher price level. When the economy faces higher costs, cost-push
inflation occurs and the AS curve shifts upward to higher price levels. The AS–AD diagram
is also widely used as a pedagogical tool to model the effects of various macroeconomic
policies.
 A traditional AS–AD diagram showing a shift in AD and the AS curve becoming
inelastic beyond potential output.

Factors Affecting Aggregate Demand And Aggregate Supply

 Factors that Affect Aggregate Demand

1. Net Export Effect

 When domestic prices increase, then demand for imports increases (since domestic goods
become relatively expensive) and demand for export decreases.

2. Real Balances

When inflation increases, real spending decreases as the value of money decreases. This
shifts Aggregate Demand to the left/decreases.

3. Interest Rate Effect

Real Interest is the nominal interest rate adjusted to the inflation rate. When inflation
increases, nominal interest rates increase to maintain real interest rates. Lower real interest
rates will lower the costs of major products such as cars, large appliances and houses; they
will increase business capital project spending because long-term costs of investment projects
are reduced

4. Inflation Expectations

If consumers expect inflation to go up in the future, they will tend to buy now causing
aggregate demand to increase or shift to the right.

 Factors that Affect Aggregate Supply

1. Supply Shocks
 Adverse supply shocks shift AS to the left, i.e., a decrease in the AS curve. Usually, a
huge rise in oil prices can cause a supply shock. Natural catastrophes or hikes in taxes can
also shift AS to the left. It is either a leftward shift in the short run AS curve (the one on the
left) or by the leftward shift in the vertical long-run AS curve. However, the long run AS
curve is best suited for natural disasters or setbacks in the economy, such as corrupt
governments.

2. Resource Price Changes

Changes in the short run resource prices can alter the Short Run Aggregate Supply curve.
Unless the price changes reflect differences in long-term supply, the Long Run Aggregate
Supply is not affected.

3. Changes in Expectations for Inflation

If suppliers expect goods to sell at much higher prices in the future, they will be less
willing to sell in the current period. As a result, the Short Run Aggregate Supply will shift to
the left.

4. Capacity Increase

A rightward or an increase in AS implies an increase in productive capacity of the

economy. You can think of this as an outward shift in the production possibility curve. An
increase in the quality and quantity of the factors of production or technological
advancements or any increase in productivity can cause the outward shift.

Governments can influence AS through Supply Side policies and improvements in health
and education services. This result can be better imagined by an increase in the Long Run
AS. An increase in natural resources can also shift the AS curve to the right.
Business Cycle

The business cycle, also known as the economic cycle or trade cycle, is the downward
and upward movement of gross domestic product (GDP) around its long-term growth
trend.The length of a business cycle is the period of time containing a single boom and
contraction in sequence. These fluctuations typically involve shifts over time between periods
of relatively rapid economic growth (expansions or booms), and periods of relative stagnation
or decline (contractions or recessions). Business cycles are usually measured by considering
the growth rate of real gross domestic product. Despite the often-applied term cycles, these
fluctuations in economic activity do not exhibit uniform or predictable periodicity.

Characteristics Of A Business Cycle

1] Occur Periodically

As we saw, these phases occur from time to time. However they do not occur in for specific
times, their time periods will vary according to the industries and the economic conditions. Their
duration may vary from anywhere between two to ten or even twelve years. Even the intensity
of the phases will be different. For example, the firm may see tremendous growth followed by a
shallow short-lived depression phase.

2] They are Synchronic

Another one of the features of business cycles is that they are synchronic. Business cycles are
not limited to one firm or one industry. They originate in the free economy and are pervasive in
nature. A disturbance in one industry quickly spreads to all the other industries and finally
affects the economy as a whole. For example, a recession in the steel industry will set off a chain
reaction until there is a recession in the entire economy.

3] All Sectors are Affected

 All major sectors of the economy will face the adverse effects of a business cycle. Some
industries like the capital goods industry, consumer goods industry may be disproportionately
affected. SO the investment and the consumption of capital goods and durable consumer goods
face the maximum brunt of the cyclic fluctuations. Non-durable goods do not face such
problems generally.

4] Complex Phenomenon

Business cycles are a very complex and dynamic phenomenon. They do not have any
uniformity. There are no set causes for business cycles as well. So it is nearly impossible to
predict or prepare for these business cycles.

5] Affect all Departments

Trade cycles are not only limited to the output of goods and services. It has an effect on all
other variables as well such as employment, the rate of interest, price levels, investment activity
etc.

6] International in Character

Trade cycles are contagious. They do not limit themselves to one country or one economy.
Once they start in one country they will spread to other countries and economies via trade
relations and international trade practices.

Phases Of A Business Cycle

1. 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 characterised 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 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.

2. 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 utilised in a better way. General price level starts rising. The
recovery phase, however, gets gradually cumulative and income, employment, profit, price,
etc., start increasing.

3. 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 characterised by an
allround 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. On the other hand, demand, price level, and cost of production will
rise. During prosperity, existing capacity of plants is overutilised. 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.

4. Recession:
Like depression, prosperity or pea, 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 then 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.

REFERENCE
  https://en.wikipedia.org/wiki/Macroeconomics#/media/File:AS_%2B_AD_graph.svg
 https://en.wikipedia.org/wiki/Macroeconomics
 http://www.amosweb.com/cgi-bin/awb_nav.pl?
s=wpd&c=dsp&k=macroeconomic+sectors
 http://www.economicsdiscussion.net/business-cycles/business-cycle-definition-
characteristics-and-phases-with-diagram/6184
 https://en.wikipedia.org/wiki/Business_cycle
 https://www.toppr.com/guides/business-economics/business-cycles/features-of-
business-cycles/
 https://www.intelligenteconomist.com/aggregate-demand-and-aggregate-supply/

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