Chapter 8: Introduction To Macroeconomics 1. Introduction

ECONOMICS STUDY GUIDE

Chapter 8 – Introduction to Macroeconomics (Updated: Jan 2021)
Chapter 8:
Introduction to Macroeconomics
1. Introduction
At the aggregate level, macroeconomists are concerned things such as the total
spending and total output in the economy. Instead of focusing on individual markets
like in microeconomics, we now shift our perspectives to a broader level – that of
looking at entire countries as a whole. At this level, we are interested in indicators
such as Gross Domestic Product, unemployment rate and so on. The next section
presents a model that looks at the entire economy.

2. Circular Flow of Income model
The model below presents a two-sector economy, comprising the households and
firms.

(Diagram taken from Economics Discussion)

Firms earn revenue from households, which spend on their output of goods and
services. For instance, the economy produces a range of tangible goods such as
shirts, shoes and food, and intangible services such as haircuts and insurance
policies. Firms gain revenue from households when the latter spend their income on
such products. We say this exchange takes place in the product market (output
market) as shown above.

For households, they will gain income when they provide the factors of production. It
is assumed that households own all the factors of production – labour, capital,
entrepreneurship, land. By providing such F.O.Ps to firms, households will earn
factor income. We say this exchange takes place in the factor market (input market)
as shown above. Assuming households and firms spend every dollar they earn,
income earned by households will be the same as their expenditure. At the
aggregate level, we say national income = national expenditure. The model thus
shows the flow of income in the economy, from one group to another. Consider a
Copyright 2021. Written by Desmond Lim (MSc Financial Economics, SMU) -‐ 1 -‐
third concept: the production value. For households to have expenditure of any
amount, production value has to be the same. For instance, if $5 billion of income
was spent on goods and services last year, $5 billion of output must have been
produced. If not, there would not be this expenditure. Hence we now have the
following:

national income = national expenditure = national output

Thus we derive three ways to measure the national income (or GDP) of an economy.

Output method This measures the actual value of the goods and services
produced. This is calculated by summing all the values of output produced by firms.
Only the value of the goods and services which is sold to consumers are added;; the
value which they are worth at the various production stages are not included, so that
the same goods are not “double counted”.

Income method This measures the value of the income earned by the various
factor inputs in the economy.

Expenditure method This measures the value of all spending on goods and
services in the economy, from the different sectors. These include spending by
households (consumption spending), spending by firms (investment spending),
spending by governments (government spending) and spending by foreigners (net
exports).

2.1 Leakages and Injections
However, it may not be realistic to assume households spend every dollar they earn.
The size of the income flow is likely to change over time, due to various reasons.
They are explained below.

Leakages These reduce the size of the income flow, as households only spend part
of their incomes on goods and services produced by domestic firms. There are three
types of leakages (or ‘withdrawals’).

Savings When households save, they would not be spending on current
consumption of output. For instance, Singapore has an average savings rate of 48%
out of its GDP1. This implies that Singaporeans save almost half of their income, for
reasons such as preparation for retirement, for large expenses and so on.

1
Refer to https://www.investopedia.com/articles/personal-‐finance/022415/top-‐10-‐countries-‐save-‐most.asp
for the list of top 10 countries. Information on the year was omitted.
Tax expenditure There are a variety of taxes, such as goods and service tax, excise
tax, income tax among others. These will reduce the amount that households are
able to spend on output, as part of their income is now flowing to the government.
For instance, the Singapore government imposes a 7% GST on the purchase of
goods and services.

Import expenditure The size of income flow reduces, as income flows out of the
domestic economy, into the foreign countries. The more consumers spend on foreign
goods, the less they spend on domestic products. For instance, the import as a
percentage of Singapore’s GDP has shown a decrease over the years. 2

On the other hand, there are factors that increase the size of income flow in an
economy.

Injections These increase the size of the income flow. Expenditure on domestic
goods and services come from sources other than households. There are three
types of injections.

Investment expenditure Firms borrow money from financial institutions, and use the
money on buying capital goods (machines, new equipment) for production. More
income then flows to firms producing capital goods in the economy.

Government expenditure The government spends on goods and services using the
tax revenue collected from the households and firms. For instance, the government
may operate schools and hospitals. The wages paid to teachers and doctors would
be part of this expenditure. Note that transfer payments are not included here.
Transfer payments are meant to reduce the taxes paid;; they are given like subsidies,
and would reduce the withdrawal from taxes instead.)

Export expenditure These come from the foreigners who buy goods and services
produced by the domestic firms. When they spend on domestic products, the income
flow will enter the domestic economy, thus increasing the size of the income flow.

2
Refer to https://tradingeconomics.com/singapore/imports-‐of-‐goods-‐and-‐services-‐percent-‐of-‐gdp-‐wb-‐
data.html.
2.2 Relationship between Leakages and Injections

Generally, when leakages are more than injections, there is an overall reduction in
the size of the income flow. If injections are more, there is an overall increase in the
income flow instead.

Injections, however, enjoy a special relationship with leakages. Each injection is
“paired” with a leakage, through a party in the economy. For instance, taxes reduce
the income flow size. However, the government uses this tax revenue to fund its
expenditure, injecting into the economy. The savings that leak out from the economy
are borrowed by firms through the banks, and spent as investment expenditure.

To extend further from the earlier diagram, we use the diagram below.

(Diagram taken from Pinterest)

The model above shows the relationship between households, firms, government
and the foreign sector in the economy. In addition to the two-sector economy model
we developed previously, in which there were only households and firms, the
economy now consists of the financial institutions, foreign countries and the
government. They all have a role to play in determining the level of national income
in a country.
3. Macroeconomic Objectives
In measuring the health of the economy, economists often refer to various indicators.
These indicators measure different aspects of the economy, and provide specific
views that when put together, may present the economy as a whole. They are
discussed below.

3.1 High, inclusive and sustainable economic growth
Economic growth is calculated below:
𝑛𝑒𝑤 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃 − 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃 = 𝑋 100%
𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃

The indicator to measure economic growth is real GDP. GDP, or Gross Domestic
Product, is explained below.

GDP refer to the market value of all final goods and services produced within a region
within a period of time.

• Market Value: calculated from the market prices of many different kinds of
products
• Of all: includes all items produced in the economy and sold legally in markets
(items produced and sold illegally are excluded;; goods produced and consumed
at home are excluded – these are referred to as the ‘underground’ economy)
• Final: only includes the value of final goods (goods that reach the consumers), not
intermediate goods
• Produced: includes goods and services currently produced
• Within a country: value of production within the geographic confines of a country
or continent
• In a given period of time: production that takes place within a specific interval of
time (3 months, 1 year)

The term ‘real GDP’ was mentioned above. We contrast this with ‘nominal GDP’, which
is GDP not adjusted for inflation;; that is, it still carries the influence of the inflation in
its calculation, to give a GDP figure that is more than what it is supposed to be. We
use the table below for illustration.

(Diagram taken from Quickonomics)

Suppose we wish to calculate the GDP change from 2015 to 2016 of the above country,
which produces only ice cream and candy bars, to measure the amount of economic
growth.
For 2015: 100,000 𝑥 $2 + 200,000 𝑥 $1 = $400,000
For 2016: 120,000 𝑥 $2.50 + 220,000 𝑥 $2 = $740,000
MNO,OOOPNOO,OOO
Percentage change in GDP: 𝑥 100% = 85%
NOO,OOO
Can we say that national output increased by 85%? (GDP measures national output)
If we do, it would be misleading, as the production levels of ice cream and candy bars
did not increase by that extent. Instead, it was the combined effects of price and
quantity increases in both goods that led to GDP increasing by 85%. This leads us to
nominal GDP – GDP calculated using current year prices.

To make a more meaningful comparison, we would use the real GDP instead.
For 2015: 100,000 𝑥 $2 + 200,000 𝑥 $1 = $400,000
For 2016: 120,000 𝑥 $2 + 220,000 𝑥 $1 = $460,000 (we will use 2015’s price to
calculate now – that is, we hold the prices of both goods the same to strip away the
effects of price changes)
NSO,OOOPNOO,OOO
Percentage change in GDP: 𝑥 100% = 15%
NOO,OOO
The changes in national output may then be said to be 15%. This leads us to real GDP
– GDP calculated using base year prices. Note that the base year may be any year
designated by the government. For instance, Singapore uses 2015 as the base year
currently3.

Apart from GDP, economists also frequently use the Gross National Income (GNI)
indicator. GNI is the total income that is earned by a country’s factors of production
regardless of where the assets are located. For instance, profits earned by an Indian
MNC located in Japan would be included in India’s GNI, but Japan’s GDP. The
calculation for deriving GNI from GDP is as follows:

GNI = GDP + income earned from assets abroad – income paid to foreign assets
operating domestically

Economists often favour high economic growth to a low one. Higher economic growth
would indicate that more production is taking place, and households have more goods
and services they can consume. It may also indicate that national income levels are
higher, which households may spend on purchasing more goods and services;; their
purchasing powers have increased. This can suggest an improvement in the material
standard of living (explained later on in this chapter).

Failure to achieve high economic growth may then result in high unemployment rates,
low national income levels, low material standard of living and so forth. For instance,
due to COVID-19 and the Circuit Breaker measures, Singapore reported a 12.6% year
on year fall in real GDP for Q2 20204.

At this point, we differentiate between actual output and potential output. When the
GDP grows from one period to the next, we say there is an increase in actual output
of the economy. Potential output, on the other hand, refers to the amount of goods
3
As at 11 December 2019. Refer to https://www.singstat.gov.sg/find-‐data/search-‐by-‐
theme/economy/national-‐accounts/latest-‐data.
4
See https://www.straitstimes.com/business/economy/singapore-gdp-plunges-126-in-q2-worse-than-expected-
flash-data for the write up.
and services the economy can produce at the maximum, if all factors of production are
employed.

Inclusive growth This focuses on including everyone, even those of lower income
groups, in the pursuit of economic growth. In other words, this focuses on reducing
income inequality in the economy. For Singapore, instead of relying on the government
for income redistribution through cash payouts (transfer payments), the focus is on
building on skills to ensure higher productivity. Workers are given opportunities and
subsidies for training, such as through the SkillsFuture Mid-Career Enhanced Subsidy5.
To measure income inequality, the Gini coefficient is used to measure the dispersion
of income among households in a country. For Singapore, the latest data showed that
the coefficient stood at 0.3566, slightly higher than that in other countries. A value
closer to 0 indicates perfect income equality, while a value of 1 indicates perfect
income inequality.

Sustainable growth This refers to current economic growth that will not impede future
economic growth. This is concerned with using resources in a way that balances its
conservation while allowing economy to grow. For instance, firms that cut down trees
excessively may prevent future generations from using as many trees, if not enough
time is given to allow new trees to grow. The government may impose taxes on such
firms to discourage their production.

As with any indicator, GDP also has its limitations. Firstly, with non-marketed items,
they are not included in the calculation of GDP. For instance, a mother cooks a meal
for the family. Were this to be a good sold in the market, a transaction would have
taken place and be recorded in the real GDP. However, it is now not the case, as the
meal was just consumed without any transaction. This implies that the GDP figures
have understated the true level of production in the economy. Second, GDP ignores
externalities. In countries with high production levels, they could also be experiencing
high pollution levels. This may result in lower non-material welfare of the society, while
the GDP statistics do not reflect so. Third, GDP figures ignore the distribution of
income. While national income levels may have risen on average and in total, not
every household necessarily benefits. The lower income households may see no
increase in their level of income from before, while most of the gains in income have
flowed to the higher income groups.

3.2 Low and stable inflation rate
Inflation refers to the sustained increase in the general price level (GPL). At the
aggregate level, we are concerned with not only the price of specific goods, but that
5
refer to http://www.skillsfuture.sg/enhancedsubsidy.
6
Article published on 19 march 2018. Please see https://www.straitstimes.com/singapore/parliament-‐gini-‐
coefficient-‐here-‐higher-‐than-‐countries-‐which-‐impose-‐greater-‐overall-‐taxes.
of all goods and services produced. The GPL is thus an average price of all goods and
services.

Central Banks usually aim for an inflation rate of 2 – 3%. For instance, the Bank of
England, UK’s Central Bank, has an inflation target of 2% 7 . There is no ‘perfect’
inflation rate for every country;; this target is decided by the central bank of each
country. The reason for targeting a positive rate is to allow for actual inflation rates of
1% to 4%, which are around the targeted rates. If the target rate is set too low, there
is a higher possibility of achieving negative inflation rates, which will cause deflation.
Deflation is the sustained decrease in GPL. Having deflation may result in
households delaying purchases, as they expect prices to drop further. The economy
may be negatively affected due to the reduced spending from households, fueling
further decreases in real GDP and GPL.

A stable inflation rate is one that does not experience large changes. Huge changes
in inflation rates may deter firms from operating in the country, as it is difficult to make
decisions, especially in terms of pricing and cost. Examples of hyperinflation, where
inflation rates are more than 50%, include Venezuela (inflation rate of 481% in 2016)
and Zimbabwe (98% increase each day, in the period 2004 – 2009)8.

Inflation rate is considered a lagging economic indicator, which means that they show
changes after the overall economy has experienced a change – inflation figures thus
lag behind the economy’s performance. A reason for this is that firms are generally
slow to change the prices, especially for services, though the economy has already
showed changes in GDP levels.

3.3 Low unemployment
Unemployment is defined as people who are of working age, willing and able to work,
have been looking for work but unable to find any.

𝑛𝑜. 𝑜𝑓 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑅𝑎𝑡𝑒 = 𝑋 100%
𝑛𝑜. 𝑜𝑓 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 + 𝑛𝑜, 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

It is often the government’s aim to lower unemployment, for various reasons. Firstly,
a lower unemployment implies the government has a larger tax base (pool of people
from which to collect taxes) and can spend lesser on unemployment benefits, in
countries such as USA. For instance, the graph below shows the UK government’s
spending (in million GBP) on unemployment benefits from 2013 to 2018. A lower
spending would reduce the related opportunity costs, allowing the government to
spend on other areas instead.
7
See https://www.bankofengland.co.uk/monetary-‐policy.
8
See https://www.thebalance.com/what-‐is-‐hyperinflation-‐definition-‐causes-‐and-‐examples-‐3306097.

(Diagram taken from Statista)

Moreover, lower unemployment would lead to lower crime rates, since households
would be wealthier and not worry about daily necessities. They would have lesser
incentives to commit crimes.

Like inflation, the unemployment rate is also a lagging economic indicator. Firms wait
until downturns look serious enough, before they lay off workers;; similarly, firms wait
for recoveries to be secure before they rehire the workers. As such, the
unemployment rate changes after the rise and falls of the business cycle, a concept
explained below.
4. Business Cycle
Real output of economies fluctuate at different growth rates all the time, and often
follow a non-regular pattern. For instance, US economy ended a decade without any
recession, from 2010 to the end of 2019, since the end of the Global Finance Crisis
of 2008. This was not seen in the last decade, which saw periods of recession.
Generally, however, economies see a trend of expansion (increases in real GDP)
and contraction (decreases) over time. This is shown with the business cycle
diagram below.


(Diagram taken from IB Text)

Real GDP is plotted against time. The diagram shows various phases of the
business cycle:

Expansion When the employment of inputs increases to produce more output, and
the general price level generally increases more rapidly. Employment level
increases.

Peak Expansion of the economy has reached the maximum point, and this marks
the end of the expansion phase. Unemployment level has fallen to the lowest, and
GPL is rising very rapidly.

Contraction From the peak, the economy starts to experience negative economic
growth, shown by the downward sloping portion of the curve above. A recession
occurs if the negative economic growth lasts for two consecutive quarters or longer.
Unemployment rate starts to increase, while GPL may fall.

Trough The real GDP has reached the lowest level, and the economy may be
facing widespread unemployment at this point.

The straight line going through the curve represents the long-term growth trend of
the economy, which is the general trend of growth over time. Real GDP has fluctuate
around this trend line, which then shows us the potential output level. At this output
level, resources are used to the maximum possible – NOTE: this does not mean
zero unemployment in the economy. As there will always be some unemployment in
the economy all the time, unemployment may only fall to its lowest level possible (we
call this level the ‘natural rate of unemployment’) but not to zero.
In a nutshell, the potential output level will show us the full employment level, which
corresponds to the natural rate of unemployment.

5. Standard of Living (SOL)
This refers to the general well-being of the people in a country. Governments
generally aim for the overall level of SOL to be as high as possible, so that the
households’ welfare level is maximised. SOL has two aspects – the material and
non-material aspects.

Material aspect This is affected by the availability of goods and services for
consumption in the economy. Generally, if real GDP is higher, there are more goods
and services produced. Material SOL is thus higher. Explained another way, higher
real GDP implies that the income level of the households are higher. Households will
be able to consume more goods and services. Material SOL is thus higher too.

Other economic indicators may also imply the level of material SOL. For instance,
unemployment levels may suggest the income levels of households, or whether
there is one, which may show their purchasing power with regards to goods and
services. Similarly, the inflation rates will provide an idea of the changes in general
price levels, which may affect the affordability of goods and services.

Note, however, that economic indicators may not always suggest a certain way of
the levels of material SOL. For instance, if higher real GDP came about due to
higher exports, then the amount of output available for consumption may be limited,
as goods and services produced have been sold abroad. Material SOL may then not
be higher with higher real GDP levels.

Also, a higher real GDP level may not correspond with higher real GDP per capita
(on an average basis) if the country has a larger population or higher population
growth rate. This may then imply material SOL is not higher with higher real GDP
levels.

Non-Material aspect This refers to the qualitative aspects of SOL. It is affected by
qualities such as the cleanliness of the environment, literacy rate, the access to
healthcare and so on. An indicator may be the Human Development Index (HDI),
which measures life expectancy, expected years of schooling among others9. When
the index registers a higher score, it implies that people are living longer years and
have a higher level of education. Non-material SOL will thus be higher.

However, non-material SOL goes beyond what the HDI may measure. For instance,
pollution levels that are present in the air may not be captured by the HDI statistics.
9
Refer to http://hdr.undp.org/en/composite/HDI for the detailed data.
For SOL, we are concerned with changes in its level. This may be intertemporal
(across time), or international (across countries). For instance, the unemployment
rates of two countries, such as Singapore and China, may provide insights into the
level of material SOL of these two countries. Similarly, the different GDP per capita
levels of Singapore in the 1960s and 2000s may allow comparisons of its material
SOL. No one indicator, however, will provide a conclusive comparison of the levels
of SOL;; they will just provide evidence.


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ECONOMICS STUDY GUIDE

2.2 Relationship between Leakages and Injections

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