Last update: Saturday, September 15, 2012

Lecture 9
Objectives of lecture
 To understand the key concepts used in macroeconomic analyses.
 To understand basic macroeconomic theories of growth, inflation and the
balance of payments.

Contents of lecture
Basic concepts
 The major elements of the macroeconomy which economists use to explain
the phenomena of economic growth, inflation and the balance of payments
are PRODUCTION, INCOME, EXPENDITURE and SAVINGS.
 The value of production (which is taken to be the quantity of what is
produced times the prices of each item) is equal to the value of income,
which in turn is equal to the value of total expenditure on all goods and
services. A change in one is seen as giving rise to a change in the other such
that the equality is maintained between all three items.
o It is of note that for Heterodox economists the value of production
is equal to the value of income and the value of the revenue accruing to
firms which is required for the replacement of the material inputs used
up in the process of production, including fixed capital. Profits are the
surplus accruing to the capitalist over and above costs, where costs
include the replacement of used up inputs. That is to say, aggregate
income is equal to the aggregate net product and not aggregate gross
product.
 A crucial distinction is drawn between REAL and NOMINAL or money value
of production, income and expenditure. An economist tends to see increases
in the real value of these values positively, and increases in the nominal
values of these variables less positively.
 An important question which is asked is when the value of production rises
does it represent a real (quantity) or nominal (money price) increase.
Similarly, when the value of income rises does it represent a real or nominal
increase. A real increase in the value of income implies that the increased
value of income represents more goods and services. This would only be the
case if more goods and services were produced. It would represent a
nominal increase in income if more goods and services had not been produced.
Finally, when the value of expenditure rises a real increase would be implied
if the increase in value represented an increase in the quantity purchased.
If the increase in value simply reflected higher prices being paid then the
increase in value of expenditure is said to be a nominal increase in value.
 AGGREGATE OUTPUT is seen as comprising CONSUMPTION and
INVESTMENT goods. Consumption goods are those goods destined for final
consumption. Investment goods are those which are produced as inputs into
production. These goods include so-called fixed capital, such as machines
and factories, and working capital, such as raw materials (and also stocks of
finished goods).
 The goods and services produced in an economy are typically seen as being
produced in different sectors. At the most aggregate level these sectors
are AGRICULTURE, INDUSTRY and SERVICES. Each of these sectors is in
turn dividable into sub-sectors. For example, the industry sector is seen as
comprising manufacturing, mining and quarrying, construction, and export
processing.
 AGGREGATE INCOME is seen as comprising mostly wages (and salaries),
profits, interest and rent. It also includes surpluses of government
corporations and income of the self-employed.
 AGGREGATE EXPENDITURE is seen as comprising private consumption
expenditure (C), private investment expenditure (I), government expenditure
(G), and expenditure of foreigners on local goods (exports) minus
expenditure of locals on foreign goods (M). With respect to the latter it
needs noting that what is being sought in the expenditure estimate is how
much expenditure there is on local goods and services.
o It is of note that for Heterodox economists aggregate expenditure
includes expenditure on material inputs used up in the process of
production. This is not the same as investment expenditure – which is the
expenditure on inputs (including labour) which facilitates the expansion of
production. That is to say, the aggregate expenditure in the textbooks is
in fact aggregate net expenditure. For Neoclassicals investment
expenditure is expenditure on fixed capital with a view to the expansion
of production.
 In the simple Heterodox model it is assumed that all income received by
factors is spent directly on consumption and investment goods, or taken by
government in the form of taxes or leaks out of the system through imports.
The income received by factors which is spent directly on investment goods
is really the retained earnings of companies accruing to the owners and
managers of the companies. Neoclassicals however see the money which is
spent on investment goods as having first been saved. They see some of this
savings coming from private individuals out of income (and being transferred
to investors via the financial system), some coming from government as a
result of taxed income not spent, and yet other savings as coming from
foreign sources in the form of an excess of imports over exports. These
economists introduce the notion of AGGREGATE SAVINGS.
 AGGREGATE SAVINGS is seen as equalling aggregate investment (private
and government). It comprises PRIVATE SAVINGS, GOVERNMENT
SAVINGS and FOREIGN SAVINGS. Private savings is what individuals do
not spend on consumption goods. The tacit assumption is that this savings
 finds its way to investment financing. Government savings is defined as what
the government does not spend out of its tax income. This is sometimes
referred to as forced savings. The assumption is that this saving ends up as
investment financing. Foreign savings refers to the net resources a country
can command from outside to finance investment. It is assumed that a
surplus of imports over exports translates into resources available to finance
investment either directly or indirectly (through lowering the requirement
for domestic production of consumption goods to meet domestic consumption
demand).
 Heterodox economists typically focus on aggregate expenditure and its
components while Neoclassicals typically focus on aggregate savings and its
components. The Heterodox argument is that it is expenditure which drives
investment and therefore growth, while the Neoclassical argument is that it
is savings that drives investment and therefore growth.

Basic macroeconomic theories

Neoclassical
 Neoclassicals argue that an increase in aggregate money expenditure does
not translate into an increase in aggregate output (even if there is
unemployment). The crucial assumption that the Neoclassicals make is that
output is not responsive to changes in aggregate money expenditure, either
over the long-run or the short-run. Over the short-run it is assumed this is
because factor inputs, inlcuding labour are fixed. Over the long-run (ans also
over the short-run even if there is unemployed labour) it is assumed this is
because businesses know that prices will rise along with the increase in
expenditure so their costs will rise and therefore the increase in
expenditure is only a nominal increase in expenditure. It needs to be said
that some Neoclassicals admit to some increase in output over the short-run
because businesses make mistakes; they believe the increase in expenditure
is a real increase and not a nominal increase.
 Neoclassical economists argue that the fundamental impact of an increase in
aggregate money expenditure is inflation and a deterioration in the external
payments situation and/or a depreciation in the exchange rate.
 Neoclassicals argue that increased expenditure results in inflation in the
short-run because quantity can be assumed to be fixed, while in the long-run
(when all inputs are flexible) it results in inflation because individuals know
that increases in money expenditures will not give rise to an increase in
output only an increase in money prices (rational expectations).
 Neoclassicals argue that the increased expenditure will give rise to a
worsening balance of payments because it will cause import expenditures to
rise and the inflation, given fixed exchange rates, will cause exports to fall
(due to assumed rising export prices).
 Neoclassicals argue that the excess expenditure will also put pressure on the
exchange rate insofar as it causes an imbalance in the demand for and supply
of the local currency in relation to the foreign currency. They argue further
that the weakening currency could help rectify the imbalance by making
imports more expensive and exports cheaper. Accordingly, Neoclassicals see
balance of payments problems as resulting from a combination of excess
demand and an absence of a market-clearing exchange rate.
 Neoclassicals argue that the increase in aggregate money expenditure cannot
take place unless there is an increase in the MONEY STOCK – the money
help by individuals. Individuals may want to spend more but unless they have
more money they would not be able to do so. The principle reason advanced
for an increase in the money stock is an increase in the amount of cash in the
system. The latter is typically seen to result from the need of government
to finance their BUDGET DEFICITS.
 Neoclassicals argue that increases in economic output result from increases
in aggregate (real) savings. When real savings rise, real investment rise and
this causes output to rise. The sources of increases in real savings are
increases in domestic private and government savings and foreign savings.
The increase in private savings is due to higher real interest rates and a
development of the financial system. Increases in government savings is due
to a reduction in the budget deficit. The increase in foreign savings is due
to an increase in the trade deficit, which is funded by an inflow of foreign
capital. In the context of developing countries Neoclassicals also see
“institutional factors” (like property rights, price liberalisation, free trade,
etc) playing a role in promoting economic growth.
o Some commentators note that the requirement for a trade deficit in
respect of foreign savings contradicts the view that the trade deficit is
seen as a negative product of increases in expenditure resulting from an
increase in the money stock. However, Neoclassicals would contend that
the latter increase in the trade deficit has no implications for output
expansion (and therefore a long-term improvement in the trade deficit)
unlike the increase in foreign savings.

Heterodox
 For Heterodox economists an increase in aggregate expenditure leads to an
increase in aggregate output. The increase in expenditure is seen as giving
rise to an increase in investment (by causing profits and, therefore,
expected profits to rise). The rise in actual profits provides the necessary
finance for investment (i.e., the savings). The key emphases of Heterodox
economists with regard to expenditure tend to be on government spending
(G), and net exports (X-M).
 For Heterodox economists inflation is explained for the most part by cost
increases (note from the microeconomic analysis prices are cost plus a mark-
up). Increases in aggregate expenditure typically are not the main source of
inflation.
 When explaining the balance of payments, Heterodox economists draw a
distinction between advanced and developing countries, and for developing
countries between manufacturing producers/exporters and primary goods
producers/exporters. For advanced economies and developing country
manufacturers what matters in the explanation of balance of payments
trends is relative costs and the competitiveness of the exchange rate.
Countries with relatively high costs (labour and others), and/or a non-
competitive exchange rate, will tend to have weak balance of payments. For
Heterodox economists a competitive exchange rate is one which promotes
exports and domestic import-substituting producers (see lecture 10 notes
for a further explanation of this point). Excess demand pressures can
explain balance of payments problems at some junctures and for a few
countries. For raw material and other primary producing countries balance
of payments problems are typically explained by adverse trends in their
terms of trade and foreign debt servicing costs.
 Heterodox economists argue that changes in the money stock are typically
induced by the prior demand of individuals for more money and that
governments are for the most part powerless to resist increases in the
demand for money. That is to say changes in the money stock are seen to be
“endogenous” – determined by the economic system and not government.