Notes on Introduction to Macroeconomics – Unit 1

Subject: Managerial Economics 2; Semester: 1

Q.1 What Is Macroeconomics? Explain the concept, scope and importance and imitations of
macroeconomics.

Macroeconomics is a branch of economics that studies how an overall economy—the market or other
systems that operate on a large scale—behaves. Macroeconomics studies economy-wide phenomena
such as inflation, price levels, rate of economic growth, national income, gross domestic product (GDP),
and changes in unemployment.

Some of the key questions addressed by macroeconomics include: What causes unemployment? What
causes inflation? What creates or stimulates economic growth? Macroeconomics attempts to measure
how well an economy is performing, to understand what forces drive it, and to project how
performance can improve.

Macroeconomics deals with the performance, structure, and behavior of the entire economy, in
contrast to microeconomics, which is more focused on the choices made by individual actors in the
economy (like people, households, industries, etc.).

There are two sides to the study of economics: macroeconomics and microeconomics. As the term
implies, macroeconomics looks at the overall, big-picture scenario of the economy. Put simply, it focuses
on the way the economy performs as a whole and then analyzes how different sectors of the economy
relate to one another to understand how the aggregate functions. This includes looking at variables like
unemployment, GDP, and inflation. Macroeconomists develop models explaining relationships between
these factors. Such macroeconomic models, and the forecasts they produce, are used by government
entities to aid in the construction and evaluation of economic, monetary, and fiscal policy; by businesses
to set strategy in domestic and global markets; and by investors to predict and plan for movements in
various asset classes.

Given the enormous scale of government budgets and the impact of economic policy on consumers and
businesses, macroeconomics clearly concerns itself with significant issues. Properly applied, economic
theories can offer illuminating insights on how economies function and the long-term consequences of
particular policies and decisions. Macroeconomic theory can also help individual businesses and
investors make better decisions through a more thorough understanding of the effects of broad
economic trends and policies on their own industries.

Limits of Macroeconomics

It is also important to understand the limitations of economic theory. Theories are often created in a
vacuum and lack certain real-world details like taxation, regulation, and transaction costs. The real world
is also decidedly complicated and includes matters of social preference and conscience that do not lend
themselves to mathematical analysis. Even with the limits of economic theory, it is important and
worthwhile to follow the major macroeconomic indicators like GDP, inflation, and unemployment. The
performance of companies, and by extension their stocks, is significantly influenced by the economic
conditions in which the companies operate and the study of macroeconomic statistics can help an
investor make better decisions and spot turning points.

Likewise, it can be invaluable to understand which theories are in favor and influencing a particular
government administration. The underlying economic principles of a government will say much about
how that government will approach taxation, regulation, government spending, and similar policies. By
better understanding economics and the ramifications of economic decisions, investors can get at least
a glimpse of the probable future and act accordingly with confidence.

Scope and importance of Macroeconomics

Macroeconomics is a rather broad field, but two specific areas of research are representative of this
discipline. The first area is the factors that determine long-term economic growth, or increases in the
national income. The other involves the causes and consequences of short-term fluctuations in national
income and employment, also known as the business cycle.

Economic Growth

Economic growth refers to an increase in aggregate production in an economy. Macroeconomists try to

understand the factors that either promote or retard economic growth in order to support economic
policies that will support development, progress, and rising living standards. Adam Smith's classic 18th-
century work, An Inquiry into the Nature and Causes of the Wealth of Nations, which advocated free
trade, laissez-faire economic policy, and expanding the division of labor, was arguably the first, and
certainly one of the seminal works in this body of research. By the 20th century, macroeconomists
began to study growth with more formal mathematical models. Growth is commonly modeled as a
function of physical capital, human capital, labor force, and technology.

Business Cycles

Superimposed over long term macroeconomic growth trends, the levels and rates-of-change of major
macroeconomic variables such as employment and national output go through occasional fluctuations
up or down, expansions and recessions, in a phenomenon known as the business cycle. The 2008
financial crisis is a clear recent example, and the Great Depression of the 1930s was actually the impetus
for the development of most modern macroeconomic theory.

History of Macroeconomics

While the term "macroeconomics" is not all that old (going back to the 1940s), many of the core
concepts in macroeconomics have been the focus of study for much longer. Topics like unemployment,
prices, growth, and trade have concerned economists almost from the very beginning of the discipline,
though their study has become much more focused and specialized through the 20th and 21st centuries.
Elements of earlier work from the likes of Adam Smith and John Stuart Mill clearly addressed issues that
would now be recognized as the domain of macroeconomics.

Macroeconomics, as it is in its modern form, is often defined as starting with John Maynard Keynes and
the publication of his book The General Theory of Employment, Interest, and Money in 1936. Keynes
offered an explanation for the fallout from the Great Depression, when goods remained unsold and
workers unemployed. Keynes's theory attempted to explain why markets may not clear.

Prior to the popularization of Keynes' theories, economists did not generally differentiate between
micro- and macroeconomics. The same microeconomic laws of supply and demand that operate in
individual goods markets were understood to interact between individuals markets to bring the
economy into a general equilibrium, as described by Leon Walras. The link between goods markets and
large-scale financial variables such as price levels and interest rates was explained through the unique
role that money plays in the economy as a medium of exchange by economists such as Knut Wicksell,
Irving Fisher, and Ludwig von Mises.Throughout the 20th century, Keynesian economics, as Keynes'
theories became known, diverged into several other schools of thought.

Q.2 Explain the Classical Theory and long-run theory of Macroeconomics.

Classical

Classical economists held that prices, wages, and rates are flexible and markets tend to clear unless
prevented from doing so by government policy, building on Adam Smith's original theories. The term
“classical economists” is not actually a school of macroeconomic thought, but a label applied first by Karl
Marx and later by Keynes to denote previous economic thinkers with whom they respectively disagreed,
but who themselves did not actually differentiate macroeconomics from microeconomics at all.

Keynesian

Keynesian economics was largely founded on the basis of the works of John Maynard Keynes, and was
the beginning of macroeconomics as a separate area of study from microeconomics. Keynesians focus
on aggregate demand as the principal factor in issues like unemployment and the business cycle.
Keynesian economists believe that the business cycle can be managed by active government
intervention through fiscal policy (spending more in recessions to stimulate demand) and monetary
policy (stimulating demand with lower rates). Keynesian economists also believe that there are certain
rigidities in the system, particularly sticky prices that prevent the proper clearing of supply and demand.

Monetarist
The Monetarist school is a branch of Keynesian economics largely credited to the works of Milton
Friedman. Working within and extending Keynesian models, Monetarists argue that monetary policy is
generally a more effective and more desirable policy tool to manage aggregate demand than fiscal
policy. Monetarists also acknowledge limits to monetary policy that make fine tuning the economy ill
advised and instead tend to prefer adherence to policy rules that promote stable rates of inflation.

New Classical

The New Classical school, along with the New Keynesians, is built largely on the goal of integrating
microeconomic foundations into macroeconomics in order to resolve the glaring theoretical
contradictions between the two subjects. The New Classical school emphasizes the importance of
microeconomics and models based on that behavior. New Classical economists assume that all agents
try to maximize their utility and have rational expectations, which they incorporate into macroeconomic
models. New Classical economists believe that unemployment is largely voluntary and that discretionary
fiscal policy is destabilizing, while inflation can be controlled with monetary policy.

New Keynesian

The New Keynesian school also attempts to add microeconomic foundations to traditional Keynesian
economic theories. While New Keynesians do accept that households and firms operate on the basis of
rational expectations, they still maintain that there are a variety of market failures, including sticky
prices and wages. Because of this "stickiness", the government can improve macroeconomic conditions
through fiscal and monetary policy.

Austrian

The Austrian School is an older school of economics that is seeing some resurgence in popularity.
Austrian economic theories mostly apply to microeconomic phenomena, but because they, like the so-
called classical economists never strictly separated micro- and macroeconomics, Austrian theories also
have important implications for what are otherwise considered macroeconomic subjects. In particular
the Austrian business cycle theory explains broadly synchronized (macroeconomic) swings in economic
activity across markets as a result of monetary policy and the role that money and banking play in linking
(microeconomic) markets to each other and across time.

Q.3 How is Macroeconomics different from Microeconomics?

Macroeconomics differs from microeconomics, which focuses on smaller factors that affect choices
made by individuals and companies. Factors studied in both microeconomics and macroeconomics
typically have an influence on one another. For example, the unemployment level in the economy as a
whole has an effect on the supply of workers from which a company can hire.

A key distinction between micro- and macroeconomics is that macroeconomic aggregates can
sometimes behave in ways that are very different or even the opposite of the way that analogous
microeconomic variables do. For example, Keynes referenced the so-called Paradox of Thrift, which
argues that while for an individual, saving money may be the key building wealth, when everyone tries
to increase their savings at once it can contribute to a slowdown in the economy and less wealth in the
aggregate.

Meanwhile, microeconomics looks at economic tendencies, or what can happen when individuals make
certain choices. Individuals are typically classified into subgroups, such as buyers, sellers, and business
owners. These actors interact with each other according to the laws of supply and demand for
resources, using money and interest rates as pricing mechanisms for coordination.

Q.4 Whether macroeconomics is a science or an art?

Before we start discussing whether economics is science or not, it becomes necessary to have a clear
idea about science. Science is a systematic study of knowledge and fact which develops the correlation-
ship between cause and effect. Science is not only the collection of facts, according to Prof. Poincare, in
reality, all the facts must be systematically collected, classified and analyzed.

These following characteristics are of any science subject:

(i) It is based on systematic study of knowledge or facts;

(ii) It develops correlation-ship between cause and effect;

(iii) All the laws are universally accepted;

(iv) All the laws are tested and based on experiments;

(v) It can make future predictions;

(vi) It has a scale of measurement.

On the basis of all these characteristics, it can be said that macroeconomics/economics is a science.

However, the most important question is whether economics is a positive science or a normative
science? Positive science deals with all the real things or activities. It gives the solution what is? What
was? What will be? It deals with all the practical things. For example, poverty and unemployment are
the biggest problems in India. The life expectancy of birth in India is gradually rising. All these above
statements are known as positive statements. These statements are all concerned with real facts and
information.

On the contrary, normative science deals with what ought to be? What ought to have happened?
Normative science offers suggestions to the problems. The statements dealing with these suggestions
are coming under normative statements. These statements give the ideas about both good and bad
effects of any particular problem or policy. For example, illiteracy is a curse for Indian economy. The
backwardness of Indian economy is due to ‘population explosion’.
The following statements can ensure economics as a normative science, such as:

Emotional View:

A rational human being has not only logical view but also has sentimental attachments and emotional
views regarding any activity. These emotional attachments are all coming under normative statements.
Hence, economics is a normative science.

(ii) Welfare Activity:

Economics is a science of human welfare, All the economic forwarded their theories for the
development of human standard of living Hence, all the economic statements have their respective
normative views.

(iii) Economic Planning:

Economic planning is one of the main instruments of economic development. Several economists have
given their personal views for the successful implementation of economic plan. Hence, economics is
coming under normative science. All these lead us to the conclusion that ‘Economics’ is both positive
and normative science. It does not only tell us why certain things happen however, it also gives idea
whether it is right thing to happen.

Economics as an Art:

According to Т.К. Mehta, ‘Knowledge is science, action is art.’ According to Pigou, Marshall etc.,
economics is also considered as an art. In other way, art is the practical application of knowledge for
achieving particular goals. Science gives us principles of any discipline however, art turns all these
principles into reality. Therefore, considering the activities in economics, it can claimed as an art also,
because it gives guidance to the solutions of all the economic problems. Therefore, from all the above
discussions we can conclude that economics is neither a science nor an art only. However, it is a golden
combination of both. According to Cossa, science and art are complementary to each other. Hence,
economics is considered as both a science as well as an art.

Q.5 Explain the Nature of Macroeconomics system.

Macroeconomics is the study of aggregates or averages covering the entire economy, such as total
employment, national income, national output, total investment, total consumption, total savings,
aggregate supply, aggregate demand, and general price level, wage level, and cost structure. In other
words, it is aggregative economics which examines the interrelations among the various aggregates,
their determination and causes of fluctuations in them. Thus in the words of Professor Ackley,
“Macroeconomics deals with economic affairs in the large, it concerns the overall dimensions of
economic life. It looks at the total size and shape and functioning of the “elephant” of economic
experience, rather than working of articulation or dimensions of the individual parts. It studies the
character of the forest, independently of the trees which compose it.”

Macroeconomics is also known as the theory of income and employment, or simply income analysis. It is
concerned with the problems of unemployment, economic fluctuations, inflation or deflation,
international trade and economic growth. It is the study of the causes of unemployment, and the
various determinants of employment. In the field of business cycles, it concerns itself with the effect of
investment on total output, total income, and aggregate employment. In the monetary sphere, it studies
the effect of the total quantity of money on the general price level.

In international trade, the problems of balance of payments and foreign aid fall within the purview of
macroeconomic analysis. Above all, macroeconomic theory discusses the problems of determination of
the total income of a country and causes of its fluctuations. Finally, it studies the factors that retard
growth and those which bring the economy on the path of economic development.

Q.6 What is the Scope and Importance of Macroeconomics?

As a method of economic analysis macroeconomics is of much theoretical and practical importance.

(1) To Understand the Working of the Economy:

The study of macroeconomic variables is indispensable for understanding the working of the economy.
Our main economic problems are related to the behaviour of total income, output, employment and the
general price level in the economy.

These variables are statistically measurable, thereby facilitating the possibilities of analysing the effects
on the functioning of the economy. As Tinbergen observes, macroeconomic concepts help in “making
the elimination process understandable and transparent”. For instance, one may not agree on the best
method of measuring different prices, but the general price level is helpful in understanding the nature
of the economy.

(2) In Economic Policies:

Macroeconomics is extremely useful from the point of view of economic policy. Modern governments,
especially of the underdeveloped economies, are confronted with innumerable national problems. They
are the problems of overpopulation, inflation, balance of payments, general underproduction, etc.

The main responsibility of these governments rests in the regulation and control of overpopulation,
general prices, general volume of trade, general outputs, etc. Tinbergen says: “Working with
macroeconomic concepts is a bare necessity in order to contribute to the solutions of the great
problems of our times.” No government can solve these problems in terms of individual behaviour. Let
us analyse the use of macroeconomic study in the solution of certain complex economic problems.
(i) In General Unemployment: The Keynesian theory of employment is an exercise in macroeconomics.
The general level of employment in an economy depends upon effective demand which in turn depends
on aggregate demand and aggregate supply functions.

Unemployment is thus caused by deficiency of effective demand. In order to eliminate it, effective
demand should be raised by increasing total investment, total output, total income and total
consumption. Thus, macroeconomics has special significance in studying the causes, effects and
remedies of general unemployment.

(ii) In National Income: The study of macroeconomics is very important for evaluating the overall
performance of the economy in terms of national income. With the advent of the Great Depression of
the 1930s, it became necessary to analyse the causes of general overproduction and general
unemployment.

This led to the construction of the data on national income. National income data help in forecasting the
level of economic activity and to understand the distribution of income among different groups of
people in the economy.

(iii) In Economic Growth: The economics of growth is also a study in macroeconomics. It is on the basis
of macroeconomics that the resources and capabilities of an economy are evaluated. Plans for the
overall increase in national income, output, and employment are framed and implemented so as to raise
the level of economic development of the economy as a whole.

(iv) In Monetary Problems: It is in terms of macroeconomics that monetary problems can be analysed
and understood properly. Frequent changes in the value of money, inflation or deflation, affect the
economy adversely. They can be counteracted by adopting monetary, fiscal and direct control measures
for the economy as a whole.

(v) In Business Cycles: Further macroeconomics as an approach to economic problems started after the
Great Depression. Thus its importance lies in analysing the causes of economic fluctuations and in
providing remedies.

(3) For Understanding the Behaviour of Individual Units: For understanding the behaviour of individual
units, the study of macroeconomics is imperative. Demand for individual products depends upon
aggregate demand in the economy. Unless the causes of deficiency in aggregate demand are analysed, it
is not possible to understand fully the reasons for a fall in the demand of individual products.

The reasons for increase in costs of a particular firm or industry cannot be analysed without knowing the
average cost conditions of the whole economy. Thus, the study of individual units is not possible without
macroeconomics.

Thus we may conclude that macroeconomics enriches our knowledge of the functioning of an economy
by studying the behaviour of national income, output, investment, saving and consumption. Moreover,
it throws much light in solving the problems of unemployment, inflation, economic instability and
economic growth.

Limitations of Macroeconomics:

There are, however, certain limitations of macroeconomic analysis. Mostly, these stem from attempts to
yield macroeconomic generalisations from individual experiences.

1) Fallacy of Composition: In Macroeconomic analysis the “fallacy of composition” is involved, i.e.,

aggregate economic behaviour is the sum total of individual activities. But what is true of
individuals is not necessarily true of the economy as a whole. For instance, savings are a private
virtue but a public vice. If total savings in the economy increase, they may initiate a depression
unless they are invested. Again, if an individual depositor withdraws his money from the bank
there is no ganger. But if all depositors do this simultaneously, there will be a run on the banks
and the banking system will be adversely affected.

(2) To Regard the Aggregates as Homogeneous: The main defect in macro analysis is that it regards the
aggregates as homogeneous without caring about their internal composition and structure. The average
wage in a country is the sum total of wages in all occupations, i.e., wages of clerks, typists, teachers,
nurses, etc. But the volume of aggregate employment depends on the relative structure of wages rather
than on the average wage. If, for instance, wages of nurses increase but of typists fall, the average may
remain unchanged. But if the employment of nurses falls a little and of typists rises much, aggregate
employment would increase.

3) Aggregate Variables may not be Important Necessarily: The aggregate variables which form the
economic system may not be of much significance. For instance, the national income of a country is the
total of all individual incomes. A rise in national income does not mean that individual incomes have
risen. The increase in national income might be the result of the increase in the incomes of a few rich
people in the country. Thus a rise in the national income of this type has little significance from the point
of view of the community.

(4) Indiscriminate Use of Macroeconomics Misleading:

An indiscriminate and uncritical use of macroeconomics in analysing the problems of the real world can
often be misleading. For instance, if the policy measures needed to achieve and maintain full
employment in the economy are applied to structural unemployment in individual firms and industries,
they become irrelevant. Similarly, measures aimed at controlling general prices cannot be applied with
much advantage for controlling prices of individual products.

(5) Statistical and Conceptual Difficulties:

The measurement of macroeconomic concepts involves a number of statistical and conceptual

difficulties. These problems relate to the aggregation of microeconomic variables. If individual units are
almost similar, aggregation does not present much difficulty. But if microeconomic variables relate to
dissimilar individual units, their aggregation into one macroeconomic variable may be wrong and
dangerous.

Q.7 Explain the components of Fiscal policy.

Fiscal policy, in simple terms, is an estimate of taxation and government spending that impacts the
economy. There are two types of fiscal policy:

Expansionary fiscal policy: This policy is designed to boost the economy. It is mostly used in times of high
unemployment and recession. It leads to the government lowering taxes and spending more, or one of
the two. The aim is to stimulate the economy and ensure consumers' purchasing power does not
weaken.

Contractionary fiscal policy: As the term suggests, this policy is designed to slow economic growth in
case of high inflation. The contractionary fiscal policy raises taxes and cuts spending.

There are two key tools of the fiscal policy:

Taxation: Funds in the form of direct and indirect taxes, capital gains from investment, etc, help the
government function. Taxes affect the consumer's income and changes in consumption lead to changes
in real gross domestic product (GDP).

Government spending: It includes welfare programmes, government salaries, subsidies, infrastructure,

etc. Government spending has the power to raise or lower real GDP, hence it is included as a fiscal policy
tool.

Fiscal policy – objectives:

Some of the key objectives of fiscal policy are economic stability, price stability, full employment,
optimum allocation of resources, accelerating the rate of economic development, encouraging
investment, and capital formation and growth.

Q.8 What is the importance of fiscal policy?

Fiscal policy is a crucial part of the economic framework. In India, it plays a key role in elevating the rate
of capital formation, both in the public and private sectors.

The fiscal policy helps mobilise resources for financing projects. The central theme of fiscal policy
includes development activities like expenditure on railways, infrastructure, etc. Non-development
activities include spending on subsidies, salaries, pensions, etc. It gives incentives to the private sector to
expand its activities.

Fiscal policy aims to minimise income and wealth inequalities. Income tax is charged on all salaried
persons directly proportioned to their income. Likely indirect taxes are also more in the case of semi-
luxury and luxury items than that of necessary consumable items. In this way, the government generates
a good amount of revenue and that also leads to a reduction in wealth inequalities.

A prudent fiscal policy stabilises price and helps control inflation.

Fiscal policy planning gives the larger chunk of funds for regional development so as to achieve a
balanced regional development. It aims to reduce the deficit in the balance of payment.

Difference between monetary policy and fiscal policy:

Monetary policy is concerned with the management of interest rates and the total supply of money in
circulation. It is generally carried out by the RBI.

Fiscal policy, on the other hand, estimates taxation and government spending. It should ideally be in line
with the monetary policy, but since it is created by lawmakers, people's interest often takes precedence
over growth.

Q.9 What is Balance of payments and its aspects?

Balance Of Payment (BOP) is a statement which records all the monetary transactions made between
residents of a country and the rest of the world during any given period. This statement includes all the
transactions made by/to individuals, corporates and the government and helps in monitoring the flow of
funds to develop the economy. When all the elements are correctly included in the BOP, it should sum
up to zero in a perfect scenario. This means the inflows and outflows of funds should balance out.
However, this does not ideally happen in most cases.

A BOP statement of a country indicates whether the country has a surplus or a deficit of funds i.e when
a country’s export is more than its import, its BOP is said to be in surplus. On the other hand, the BOP
deficit indicates that a country’s imports are more than its exports.

Tracking the transactions under BOP is something similar to the double entry system of accounting. This
means, all the transactions will have a debit entry and a corresponding credit entry.

Q.10 Why is Balance of Payment (BOP) vital for a country?

A country’s BOP is vital for the following reasons:

The BOP of a country reveals its financial and economic status.

A BOP statement can be used as an indicator to determine whether the country’s currency value is
appreciating or depreciating.

The BOP statement helps the Government to decide on fiscal and trade policies.
It provides important information to analyze and understand the economic dealings of a country with
other countries.

By studying its BOP statement and its components closely, one would be able to identify trends that
may be beneficial or harmful to the economy of the county and thus, then take appropriate measures.

Elements/aspects of a Balance of Payment

There are three components of balance of payment viz current account, capital account, and financial
account. The total of the current account must balance with the total of capital and financial accounts in
ideal situations.

Current Account

The current account is used to monitor the inflow and outflow of goods and services between countries.
This account covers all the receipts and payments made with respect to raw materials and
manufactured goods. It also includes receipts from engineering, tourism, transportation, business
services, stocks, and royalties from patents and copyrights. When all the goods and services are
combined, together they make up to a country’s Balance Of Trade (BOT).There are various categories of
trade and transfers which happen across countries. It could be visible or invisible trading, unilateral
transfers or other payments/receipts. Trading in goods between countries are referred to as visible
items and import/export of services (banking, information technology etc) are referred to as invisible
items. Unilateral transfers refer to money sent as gifts or donations to residents of foreign countries.
This can also be personal transfers like – money sent by relatives to their family located in another
country.

Capital Account

All capital transactions between the countries are monitored through the capital account. Capital
transactions include the purchase and sale of assets (non-financial) like land and properties. The capital
account also includes the flow of taxes, purchase and sale of fixed assets etc by migrants moving
out/into a different country. The deficit or surplus in the current account is managed through the
finance from the capital account and vice versa. There are 3 major elements of a capital account:

Loans and borrowings – It includes all types of loans from both the private and public sectors located in
foreign countries.

Investments – These are funds invested in the corporate stocks by non-residents.

Foreign exchange reserves – Foreign exchange reserves held by the central bank of a country to monitor
and control the exchange rate does impact the capital account.

Financial Account
The flow of funds from and to foreign countries through various investments in real estates, business
ventures, foreign direct investments etc is monitored through the financial account. This account
measures the changes in the foreign ownership of domestic assets and domestic ownership of foreign
assets. On analyzing these changes, it can be understood if the country is selling or acquiring more
assets (like gold, stocks, equity etc).

The importance of the balance of payment is as follows:-

1) It monitors the transaction of all the imports and exports of services and goods for a given
period
2) It helps the government analyse a particular industry export growth potential and formulate
policy to sustain it
3) It gives the government a comprehensive perspective on a different range of import and export
tariffs. The government then increases and decreases the tax to discourage import and
encourage export, individually, and be self-sufficient

A country is said to be having its balance of payment in equilibrium when the sum of its current account
and non-reserve capital account equals zero, which means the current account deficit is financed
entirely by international borrowings without any movement in the country’s official reserves.

Q.11 What are Trade-Offs or Opportunity Costs in Economics?

Have you ever had to make a decision about spending your money today versus tomorrow? For
example, you might ask yourself, 'Should I go out to dinner tonight, or would I rather save my money so I
can go to the movies tomorrow?' You probably make decisions like this several times a day without even
realizing it. Since your resources - such as time and money - are limited, you must choose how to best
allocate them by making some trade-offs. Let's learn a little more about trade-offs and why
understanding this concept will help you make better decisions about your time and money.

Most of us don't have so much money that we are in a position to buy everything we desire. We must
put thought into every purchase and how it affects our bank account. We also must think about what
type of satisfaction that purchase will give us. As a result, to get one thing that we like, we usually have
to give up another thing that we also may like. Making decisions requires trading off one item against
another.

In economics, the term trade-off is often expressed as an opportunity cost, which is the most preferred
possible alternative. A trade-off involves a sacrifice that must be made to get a certain product or
experience. A person gives up the opportunity to buy 'good B,' because they want to buy 'good A'
instead. For a person going to a baseball game, their economic trade-off is the money and time spent at
the ballpark, as compared to the alternative of watching the game at home and saving their money, plus
the time spent driving to the ball game.

Q. 12 What is Circular Flow of Income?

The circular flow means the unending flow of production of goods and services, income, and
expenditure in an economy. It shows the redistribution of income in a circular manner between the
production unit and households. These are land, labour, capital, and entrepreneurship.

The payment for the contribution made by fixed natural resources (called land) is known as rent.

The payment for the contribution made by a human worker is known as wage.

The payment for the contribution made by capital is known as interest.

The payment for the contribution made by entrepreneurship is known as profit.

Circular Flow of Income in a Two-Sector Economy

This model comprises of two sectors viz. Household and Firm sectors.

It is defined as the flow of payments and receipts for goods, services, and factor services between the
households and the firm sectors of the economy. The entire amount of money, which is paid by firms as
factor payments, is paid back by the factor owners to the firms.

Circular Flow of Income in a Three-Sector Economy

This model comprises of three sectors viz. Household, Firm and Government sectors.

The three-sector economy model includes the role of government when determining the flow of money.
In this type of economy, the government plays an essential part.

A three-sector economy model rectifies some of the drawbacks of the two-sector model by introducing
the following:

1) The government plays a pivotal role in consuming a major portion of the money flow in taxes.

Hence, the flow of money follows from the firms and households to the government in taxes.

2) The government utilizes taxes to develop infrastructure and other services like healthcare,
education, etc. So, the government pays back in terms of incentives and purchases goods from
the firms.
3) The government pays the households interest rates in government securities, pay revisions,
government jobs, etc.

Together, it all completes the circular movement of money. A three-sector economy does not consider
the role of foreign markets, which has become even more prevalent in the current globalized world.

Circular Flow of Income in a Four Sector Economy

This model comprises of four sectors viz. Household, Firms, Government and Foreign sectors.
The four-sector economy model is an open-ended economy that goes beyond by considering the foreign
sector’s role in the overall economic cycle.The main features of the four-sector economy are as follows:

1) With the introduction of the foreign sector, the scope widens further. The money flows to
households or firms when they buy goods and services from a foreign country, also known as
imports.
2) The money flows back to households when foreign countries give them employment. For firms,
money flows back when foreign countries purchase goods and services, also called exports.

If the value of imports is equal to the value of exports, it is called a balanced trade. If imports are greater
than exports, it is a trade deficit.

Q.13 What Is Market Equilibrium?

Equilibrium is the state in which market supply and demand balance each other, and as a result prices
become stable. Generally, an over-supply of goods or services causes prices to go down, which results in
higher demand—while an under-supply or shortage causes prices to go up resulting in less demand. The
balancing effect of supply and demand results in a state of equilibrium.

Main points:

1) A market is said to have reached equilibrium price when the supply of goods matches demand.
2) A market in equilibrium demonstrates three characteristics: the behavior of agents is consistent,
there are no incentives for agents to change behavior, and a dynamic process governs
equilibrium outcome.
3) Disequilibrium is the opposite of equilibrium and it is characterized by changes in conditions
that affect market equilibrium.

The equilibrium price is where the supply of goods matches demand. When a major index experiences a
period of consolidation or sideways momentum, it can be said that the forces of supply and demand are
relatively equal and the market is in a state of equilibrium.

Economists like Adam Smith believed that a free market would trend towards equilibrium. For example,
a dearth of any one good would create a higher price generally, which would reduce demand, leading to
an increase in supply provided the right incentive. The same would occur in reverse order provided
there was excess in any one market.

Modern economists point out that cartels or monopolistic companies can artificially hold prices higher
and keep them there in order to reap higher profits. The diamond industry is a classic example of a
market where demand is high, but supply is made artificially scarce by companies selling fewer
diamonds in order to keep prices high.

Equilibrium vs. Disequilibrium:

When markets aren't in a state of equilibrium, they are said to be in disequilibrium. Disequilibrium can
happen in a flash in a more stable market or can be a systematic characteristic of certain markets.

At times disequilibrium can spillover from one market to another—for instance, if there aren’t enough
transport companies or resources available to ship coffee internationally then the coffee supply for
certain regions could be reduced, effecting the equilibrium of coffee markets. Economists view many
labor markets as being in disequilibrium due to how legislation and public policy protect people and
their jobs, or the amount they are compensated for their labor.

Example of Equilibrium

A store manufactures 1,000 spinning tops and retails them at $10 per piece. But no one is willing buy
them at that price. To pump up demand, the store reduces its price to $8. There are 250 buyers at that
price point. In response, the store further slashes the retail cost to $5 and garners five hundred buyers in
total. Upon further reduction of the price to $2, one thousand buyers of the spinning top materialize. At
this price point, supply equals demand. Hence $2 is the equilibrium price for the spinning tops.

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