Mist Madyabi

MACROECONOMICS 125 NOTES

NATIONAL INCOME

THE CLASSICAL THERORY OF EMPLOYMENT

The classical theory of employment was propounded by Adam Smith. According to Adam Smith
demand for labour is negatively related to real wage. That means that if real wage goes up the demand
for labour goes down. This is because the cost of production on the part of the firm increase and that
cuts into of the profits of the firm thereby reducing the incentive for the firms to demand for labour.
On the other hand supply of labour is positively related to real wage. At higher real wage more labour
is supplied

Main assumptions of the classical model

(a) Full employment of labour and other productive resource and (b) flexibility of wages and
prices to bring about full employment or equilibrium employment (c) the economy is a
competitive economy that means that means that prices in the economy are determined by the
market and not by government interventions. the government does not set price or wages.

Thus given flexibility of wages and prices, a competitive market economy would operate at full
employment and therefore forces would always be generated to ensure that demand for labour is equal
to its supply that is the labour market would be in equilibrium as shown below in the graph

Where Wo= equilibrium real wage

Lo= equilibrium labour

SL= supply of labour

DL= demand for labour

 E= point of equilibrium where supply of labour is equal to demand for labour in the labour
market.

Note that once equilibrium labour has been determined in the labour market, the next thing is to
determine how much output to be produced. Thus the production function that faces an economy
is as shown in the graph below

Note that output (Q) is a function of labour

(L) and capital (K). Note that capital (K) is
constant.

DETERMINATION OF EQUILIBRIUM FULL EMPLOYMENT AND OUTPUT

As stated above once equilibrium labour has

been determined in the labour market,
equilibrium output will now be determined.
Thus according to the classical theory of
employment both equilibrium levels of income
and employment are determined largely in the
labour market as shown in the graph.

Note that the first graph shows the

determination of equilibrium labour (Lo) and
wage (Wo) in the labour market.

In the second graph equilibrium labour (Lo)

which is determined in the labour market is
now used to produce equilibrium output (Qo).
Note that capital is held constant

Note also that (1) equilibrium labour (Lo) is

full employment and therefore any
unemployment at equilibrium wage (Wo),
must be frictional, voluntary or restrictive in
the economy or stractural (2) for equilibrium
output (Qo), there will be sufficient aggregate
demand (AD) to take up the output in order to
maintain this equilibrium. That is supply of
goods and services create its own demand and consequently there cannot be overproduction or excess
supply as compared to the demand because supply creates its own demand. This is called the Says
Law after Jean Baptise Say.

In the circular flow of income households receive income equal to the value of goods and services
produced. However part of income is saved. Consumption shortfall by savings will be mate by
investment demand for as long as investment equals savings. The equality of Savings (I) and
investment (I) is made possible because the classicals assume that there is a competitive market for
loanable funds and that interest rate is flexible. For instance if demand for loanable funds exceed
supply of loans, interest rate will go up. We know that the rate interest is a cost of borrowing,
therefore, when interest rate goes up, firms become discouraged to borrow funds for investment
because it is costly for reason that profits of a firm reduce. Therefore when interest rate increases
investment will be reducing while savings will be increasing until a point is reached when investment
and savings are equal (equilibrium) and vice versa.

In summary, the classical system depends

 Dependence of investment and savings on interest rate

 Flexible wages, prices and interest rate

 Existence of competitive forces in the economy

Keyne’s criticism of the classical theory of employment assignment: students to make notes

THE KEYNESIAN THEORY OF EMPLOYMENT

PROPOUNDED BY JOHN MAYNARD KEYNES

According to the Keynesian theory of employment, the level of real national income/output is
determined largely by the level of aggregate demand (AD). This is different from the classical model
where supply creates its demand. Therefore, under the Keynesian model; it is demand which
determines how much is supplied. For instance if firms find themselves producing more than is being
demanded, they will observe involuntary increase in their inventories of unsold goods and will cut
back on production and lay off workers. Consequently national income/output will fall until the value
of what is produced equals the value of AD and vice versa.

It follows that there will only be one level of national income at which AD is equal to the total value
of production (aggregate supply,) called the equilibrium level of income. However, the equilibrium
level of income is not necessary the same as the full employment level of income as discussed in the
classical theory of employment. Keynes therefore regarded the classical theory as no more than the
special case where the equilibrium and full employment level of income coincided

DETERMINATION OF THE EQUILIBRIUM LEVEL OF INCOME

Assumptions

(1) Wages and prices are fixed: the model is a short run one. In the short run, producers will
respond to changes in demand by changing the quantity they produce rather than price

(2) The money market is ignored and instead concentrated on the real sector of the economy that
is the market for goods and services and for labour

(3) Consumption (C) and savings (S) are both directly related to income (Y) that is linear
relationship as shown in the graph below

Note that the slope of the consumption (savings) line measures the increase in consumption (savings)
brought about by one kwacha increase income that is marginal propensity to consume and marginal
propensity to save respectively. Marginal propensity to consume (MPC) is the fraction of extra unit
of disposable income households use to consume whereas marginal propensity to save (MPS) is the
fraction of each extra unit of disposable income households wish to save. Or simply put; MPC is
increase in consumption for each K1 increase in disposable where as MPS is increase in savings
for each K1 increase disposable income. Note that MPS= 1-MPC & MPS=1-MPC

(4) Investment (I) and government spending (G), are autonomous that is they are both
independent of income changes. Government spending is determined by government policy
and investment (I) depends to some extent on the rate of interest (which for now is ignored)
and businessmen’s expectations (graph)
 (5) Taxation (T) is in the form of lump-sum taxes only for simplicity that is to see the role played
by taxes in the model while keeping the analysis simple

(6) Exports are autonomous, but imports (M) depend directly on income. Exports depend on
factors such as incomes in other countries and the exchange rate (for now assumed fixed). On
the other hand, demand for imports is (for simplicity) linearly related to income and therefore
is not autonomous.

(7) There is no economic growth. The model is concerned with the short run only.

Given these assumptions, how then is the equilibrium level of income determined in the Keynesian
model?

For equilibrium income, aggregate demand for the economy’s goods and services should just equal
to the total value of goods and services. This is the first equilibrium condition. Now recall that

AD= C+I+G+X-M ______________________________________________ (1)

Note that the value of goods and services is measure by the national income (Y)

Income (Y) made can either be spent on consumer goods, withdraw in the form of savings and taxes.
Therefore

Y= C+S+T ______________________________________________________ (2)

Therefore, as a condition for equilibrium

AD=Y which can also be written as shown below

C+I+G+X-M=C+S+T note that C crosses out hence I+G+X=S+T+M

Note that I+G+X is the injection into the income flow while S+T+M is the withdrawal from the
income flow. Note that injections are assumed to be autonomous

Note that the second condition for equilibrium level of income is that the injection and the withdrawal
must be equal

Where: AD= Aggregate Demand

W= Withdrawal

J= Injections

y= Equilibrium level of income

 E1= Equilibrium point where Y=AD

E2= Equilibrium point where W=J

In summary there are two ways of indentifying equilibrium level of income:

(1) where Aggregate demand (AD) is equal to the national income that is where the aggregate
demand line (AD) line cuts the 45o line

(2) where total injections (J) equal total withdrawals (W)

Note also that this equilibrium is a stable one in the sense that at any other income level, economic
forces will be generated to push the economy back towards the equilibrium position. For instance if
AD is more than the level of income, inventories will build up and firms would cut back on
production thereby reducing national income and vice- versa.

Limitations of the Keynesian model

(1) Does not adequately take into account problem of inflation. According to the Keynesian
model, wages and prices can only rise after attainment of full employment, yet inflation can
co-exist with unemployment

(2) It understates the influence of money on the real variables in the economy because the money
market in the Keynesian model is ignored.

MEASURING ECONOMIC PERFORMANCE

National income accounting measures the overall economic performance of an economy

Gross domestic product (GDP)

 It is taken as the main measure of economic performance

 it is defined as the market value of all final goods and services produced in an economy in a
given period of time regardless of who owns the production inputs, citizens or foreigners

Pitfalls to avoid when calculating GDP

(1) Intermediate goods and services; GDP should only include the value of final goods and
services and not the value of intermediate goods and services to avoid double or multiple
counting. one way to avoid double or multiple counting is to use the value added approach
where you sum up the value added at each stage of production
 Intermediate goods are goods and services that are still in the process of production.
They are goods that are purchased for resale or further processing or manufacturing.
They are used as input to produce other goods and services
 Final goods and services are goods and services acquired for final consumption and
not for future consumption. The goods purchased by the ultimate consumer.
(2) Non- production transactions;
Second hand sales should not be included in the calculation of GDP because the sale of the
second hand goods and services do not add to current production. In addition, their value
 when first purchased was already included in the value of GDP. Therefore, including the
value of the second hand sales would lead to multiple counting. Furthermore, the sale of the
second hand sales reflects transfer of assets.
Transfer payments; these are payments of money by the government (it could also be a
house hold making the payment) to the households or firms for which the payer receives no
goods or services directly in return
Public transfer payments; these are social insurance payments government makes to the
people e.g. welfare insurance, employment insurance payments. Public transfers should not be
included in the calculation of GDP because they do not add to the current production of final
goods and services.
Private transfer payments; these are transfers made by individuals or a household. For
instance money parents give to their children, birthday gifts, charismas gifts. Private transfers
should not be included when calculating GDP because they do not add to current production.

APPROACHES TO CALCULATING GDP

(1)EXPENDITURE APPROACH; under the expenditure approach, the money spent on buying final
goods and services is summed up. The expenditure side has four components namely, consumption,
investment, government expenditure and net exports.

PERSONAL CONSUMPTION (C); This is involves spending by the households. It has there sub
categories namely, durable goods, non- durables and services

GROSS INVESTMENT OR GROSS CAPITAL FORMATION (I); Investment has to do with the
creation of new physical capital assets- assets that creates jobs and income. Investment can be sub
divided into three subcategories

 Business fixed investment; it involves the purchase of new machinery, equipment by the
firms, new factory or construction of the factory, warehouse, storehouse
 Residential fixed investment; construction of a house or the purchase of the house are
considered as investment because a house could be rented out to earn income. A house could
also earn the owner of the house what is called the imputed rents because if the house had
been rented out it could have earned income to the owner.
 Inventories (unsold stock); the increase in unsold stock is considered as investment because
they represent unconsumed stock. Note also that inventories could increase (+) or decrease (-)

Non-investment transactions; investment does not include transfer of papers such as stock, bonds or
resale of tangible assets, investment has to do with creation f new physical capital that is capital assets
that create jobs and income.

Note also that there is a difference between gross investment and net investments. Net investment is
gross investment less depreciation.

Depreciation, also called capital consumption is defined as the rate at which the value of the existing
capital stock declines per period as a result of usage. Part of equipment or machinery used up in the
process of production. Thus depreciation is part of the production cost

GOVERNMENT EXPENDITURE; reflect what the government consumes in order to provide

public services
Net export is the final component of the expenditure approach to calculating GDP.

NE= Exports-Imports= X-M

Therefore GDP= C+I+G+X-M

INCOME APPROACH

(1) Income approach; the income approach has two sides namely the product approach and the
valued added approach. When goods and services have been produced they are sold, the
owners of the firms earn income and this income earned by the firms could be distributed as
follows; wages, interest, profits and rents.
 Interest include income paid by business to owners of capital e.g. debt capital. Interest
payment may include interest on bonds, stock, treasury bills, interest on capital e.g.
interest on loans obtained from bank
 Rent may include rent income on property e.g. house, warehouse and imputed rents
 Profits. This includes profits made by the corporate private and government firms.
note that profits made by the firms could be distributed as follows; corporate tax,
dividends and as retained profits
 Wages this include salaries and other forms of wages

When all these components are added up, we come up what is called net domestic income

NDI= wages+ interest + rent + profits

To get GDP we make adjustments to NDI by adding indirect taxes and depreciation (DEP). Examples
of indirect taxes are business property tax, customs duty, sales tax, petrol levy. Note that indirect taxes
are added to balance up the income side and the expenditure side. In calculating GDP from the
expenditure approach, indirect taxes are already included. For instance when you buy goods there is
sales tax imbedded in the price of those goods implying that in consumption there is sales tax.
However, income derived from the income does not contain indirect tax. Therefore we have to add the
indirect taxes to NDI derived from the income approach. In like manner depreciation must be added to
NDI to arrive at GDP.

Therefore GDP= NDI+DEP+INDIRECT TAX

OTHER MEASURES OF INCOME

(1) GROSS NATIOANAL PRODUCT (GNP) = GDP+ factor payments from abroad-
factor payments to abroad
Note; GNP is same as gross national income (GNI)

GNP= GDP+ factor income from abroad

(2) NET NATIOAL PRODUCT (NNP)= GNP-DEPRECIATION

NNP reflects the total national product consumed by the economy without impairing its
capacity to produce in ensuing years
 (3) NET NATIONAL INCOME (NNI)=NNP-INDIRECT TAXES; note that we subtract indirect
taxes because indirect taxes do not go to the firm but to the government and therefore, are not
part of the income of the firm
(4) PERSONAL INCOME (PI); includes all incomes received by households, earned and
unearned. Earned income is the money income received by a worker. Unearned income
includes payments such as transfer payments.
PI= NET NATIONAL INCOME or PI= NI- Corporate income tax
-CORPORATE PROFITS -undistributed profits
-SOCIAL INSURANCE CONTRIBUTION -social security
-NET INTEREST + transfer payments
+DIVIDENDS
+GOVERNMENT TRANSFERS
+PERSONAL INTEREST INCOME e.g. RENT
(5) DISPOSABLE INCOME (DI) = PI - PERSONAL TAXES - OTHER PERSONAL
TRANSFERS TO GOVT
DI= CONSUMPTION+SAVINGS

GDP VERSUS GNP

 GDP measures output in the domestic economy regardless of who owns the production
inputs that is citizens or foreigners,
 whereas GNP measures output for the domestic citizens regardless of the country where their
factor services are supplied
 GNP is used to measure GDP adjusted for net factor income from abroad

GNP VERSUS NET NATIONAL INCOME

 Net national income is calculated by subtracting depreciation and indirect taxes from GNP on
the other hand GNP includes both indirect taxes and depreciation

NOMINAL VERSUS REAL GDP

 Nominal GDP is GDP measured at current prices. Nominal GDP isn’t influenced by changes
in price levels or inflation. It is difficult to make comparisons of economic performance when
using nominal GDP across years because nominal can change either due to changes in
quantities produced or changes in prices. Hence you may not be certain as to what factor is
responsible for either the decrease or increase in nominal GDP. In addition, nominal GDP is
not a good measure of the well being of the economy
 On the other hand real GDP is measured at constant prices. It is a good measure of economic
well being of the economic performance as it is not influenced by the changes in prices. It is
easy to make comparisons of economic performance across years

Note that from the nominal GDP and real GDP we can calculate another statistic called the GDP
deflator or the implicit GDP deflator

GDP DEFLATOR= NOMINAL GDP/REAL GDP * 100

 GDP DEFLATOR is an index used to adjust nominal GDP to real GDP. It is the ratio of Nominal
GDP to real GDP. GDP deflator measures the price of the output relative to the price in the
base year. It also reflects what is happening to overall prices in the economy. Note that the other
name for the GDP deflator is the Paache index.

CONSUMER PRICE INDEX (CPI)

CPI is a measure of the price of a specified collection of goods and services called a basket in a
specific year as compared to the price of the identical collection of goods and services in the
reference or base year. The other name for CPI is Laspyres Index

Suppose a typical consumer buys 5 oranges and 2 apples every month. Then the basket of goods
consists of apples and oranges. Let us suppose that the base year is 2000, then

CPI= (5*current price of oranges) + (2* current price of apples) * 100

(5* 2000 price of oranges) + (2*2000 price of apples)

CPI could also be calculated as

CPI= price of market basket of goods and services * 100

Price of the same market basket in the base year

THE CONSUMER PRICE INDEX VERSUS THE GDP DEFLATOR

Both indices give information about what is happening to the general price levels in the economy
however they give different information;

 GDP deflator measures the prices of all goods and services produced whereas the CPI
measures the prices of only goods and services bought by consumers and therefore an
increase in the prices of goods and services bought by the firms and the government show
up in the GDP deflator but not in the CPI
 GDP deflator includes only those goods and services produced domestically and therefore
imported goods are not part of GDP and thus do not show up in the GDP deflator. For
instance an increase in price of Toyota bought from Japan affect CPI and not the GDP
deflator
 The third difference comes from the way the two indices aggregate many prices in the
economy. CPI assigns fixed weights to the prices of different goods whereas GDP
deflator assigns weights. That is CPI is computed using fixed baskets of goods and
services whereas the GDP deflator allows the basket of goods and services to change over
time

PER CAPITA INCOME AS A MEASURE OF STANDARD OF LIVING

Real per capita income could be used as a measure of standard of living in an economy. It is defined
as average income of a population or a nation’s total income per person

REAL PERCAPITA INCOME= REAL INCOME/TOTAL POPULATION

Assignment; limitations of percpita income as a measure of standard of living

(1) Percapita income implies that if percapita income is K50000, each citizen in the economy gets
K50000. But there are some people in the economy who get more than K50000. There are
also other people who get below K50000 in the same economy. Hence it does not give as a
good distribution of income in the economy

(2)

LIMITATIONS OF GDP AS A MEASURE OF ECONOMIC ACTIVITY

(1) GDP does not take into account non- market production of goods and services
(2) GDP does not account for underground economy for instance black market. Good examples
of underground economy include; gamblers, smugglers, prostitutes, drug growers and drug
dealers
(3) GDP does not take into account the qualitative dimension of the product thus if there is
improvement in the quality of the goods, the improvement in the quality of goods will not be
reflected in the measure of GDP
(4) The measure of GDP does not take into account pollution that goes with the production of
goods. Pollution reduces the economic well being of the people.
(5) GDP does not reflect how output is distributed in the society

Unemployment is the enforced idleness on labour force which is willing to accept a job at the current
wage level but cannot find a job.

The labour force is the portion of the population which is eligible to work.

Unemployment rate= unemployed labour force/Total number of labour force * 100

Labour force participation is the fraction of the population of working age who are in the labour force.
In the calculation students are excluded. unemployment is a stock measured at pointing time.

TYPES OF UNEMPLOYMENT;

 Frictional

 Structural

 Demand deficient or cyclical

 Classical

FRICTIONAL UNEMPLOYMENT
 Frictional is the irreducible minimum unemployment which occurs when people move from one job
to another. The main distinguishing feature of frictional unemployed people is that the number of jobs
equal to them, are available in the economy. This unemployment is caused mainly because of lack of
information. The employers don’t have information on the job seekers and the job seekers don’t have
information on the job vacancies.

STRUCTURAL UNEMPLOYMENT

Structural unemployment occurs because of mismatch of skills or qualifications possessed by the

employees to those required by the employers. This occurs because the economy is dynamic meaning
its change hence there is change in demand. Society keeps on changing the pattern of consumption of
goods and services. When there is too much building in the economy builders will be highly
employed however when the construction is less the builders loose employment.

CLASSICAL UNEMPLOYMENT

Classical unemployment is the unemployment created when the wage is deliberately maintained
above the level at which the labour supply and the labour demand schedules intersect. This is mainly
caused when the power of the union is great. This unemployment can be cured by reducing
government intervention in the running of the activities of the economy.

______________________________________

DEMAND-DEFFIENCY UNEMLOYMENT

This unemployment is caused due to output which is below full capacity. This is also called the
Keynesian unemployment. This unemployment is mainly caused by lack of aggregate demand. When
aggregate demand is low the firm’s stock will increase it reduce the production. In doing the labuor
will be reduced hence causing unemployment. This unemployment mainly occurs in a recession or
economic crisis. The just unemployed people will also on the less aggregate demand because they
have no means of earning income.

Full-employment does not mean all the labour force is employed. This is because there will always
be people out employment at any time. Full employment can be said to occur when the economy
experiences employment without strong inflationary pressure. Full-employment is also said to occur
only when the economy is experiencing structural and frictional unemployment. Frictional
unemployment will always occur because people are moving out of employment at any time looking
for better conditions. Some people are also termed as ‘idle rich’ because they have enough money and
cannot work for any one.

CURE FOR UNMEPLOYMENT

 Demand-deficiency can be cured by increasing aggregate-demand which will encourage

the firms to increase their production to meet the demand. In doing so, the firms will
employ more workers to increase the production. Fiscal policies can be used control
demand deficiency unemployment. AD=C+I+G+X-M, increase G(government
spending)

Fiscal and monetary policies can be used; Fiscal policies are government policies on
taxation and spending. To increase the aggregate demand, government might decide on
increasing its expenditure and reducing the taxes. Reducing the taxes means more
disposable income for consumers hence the aggregate demand will increase. Increase in
government expenditure will have a multiplier effect on rising income and employment

K= 1/1-mpc. The mpc is the marginal propensity to consume. The multiplier is the
ratio of the change in equilibrium output to the change in autonomous spending that
caused the change. Monetary policy can also be used where the rates of borrowing are
reduced hence many people will have access to the borrowing. In return the aggregate
demand will increase.