Unit 1

Introduction to Macroeconomics
Concept of Macroeconomics
The term 'macro' is derived from Greek word "makros" meaning "very big". Macroeconomics
was coined by Ragnar Frisch in 1933. Macroeconomics is the study of the economy as a whole.
The unit of study in macroeconomics is the entire economy rather than a part of it and it deals
with the problems faced by the entire economy.
According to K.E. Boulding, "Macroeconomics deals not with individual quantities as such
with aggregates of these quantities, not with individual income but with national income, not
with individual prices but with price levels, not with individual output but with national
output."
To Mc Connel, "Macroeconomics examines the forest, not the trees. It gives us a bird's eye
view of the economy."
Gardner Ackley states that, "Macroeconomics concerns the overall dimensions of economic
life. More specifically, it concerns itself with such variables as aggregate volume of an
economy, with the extent to which its resources are employed, with the size of national
income, with the general price level."
According to J.M. Culbertson, "Macroeconomic theory is the theory of income, employment,
prices and money."
P.A. Samuelson defines it as, "Macroeconomics is the study of the behavior of the economy
as a whole. It examines the overall level of nation's output, employment, prices and foreign
trade."
Macroeconomics was popular after Keynesian revolution. That is why it is popularly known
as Keynesian Economics. Macroeconomics shows nature, relationship and behavior of
economic aggregates. Macroeconomics explains the process of determining income and
employment. Therefore, it is also known as Income and Employment Theory. Macroeconomics is
also known as Lumping Method because it deals with economic aggregates, not with individual
units. Three major macroeconomic statistics are GDP, inflation and unemployment.
The features of macroeconomics can be highlighted as:
i. Study of aggregates
ii. Lumping method
iii. General equilibrium analysis
iv. Income and employment theory
v. Policy oriented
Basically, macroeconomics tries to solve the following macroeconomic issues:
 What determines the level of economic activities in an economy?
 How is the equilibrium level of national income determined?
 What causes fluctuations in the level of output and employment?
 How are price levels determined in an economy?

1
  What causes disequilibrium in balance of payments of a country?
 How does an economy respond to monetary and fiscal policies?
 What ensures the stable economic growth?

Scope / Subject Matter of Macroeconomics

The scope of macroeconomics consists of the study of the following topics:

Theory of Income and Employment

Macroeconomic Theory of Distribution

Theories of International Trade

Scope of
Macroeconomics Theory of Money and Price Level

Theory of Economic Growth

Trade Cycle

1. Theory of Income and Employment

Macroeconomic studies the concept of national income, its different components, and
methods of measurement and scope of accounting. Similarly, it also studies the process
of income and employment determination.
2. Macroeconomic Theory of Distribution
Macroeconomics studies about how the comparative share of different classes of people
in national income is determined. It also studies about the determinants of income
distribution.
3. Theories of International Trade
It studies principles determining trade among different countries. Similarly, it deals with
the fluctuation in macroeconomic variables like employment, general price level, income
and output.
4. Theory of Money and Price Level
Changes in demand and supply of money affect level of employment. Therefore, under
macroeconomics, functions and theories relating to money are studied. Similarly,
macroeconomics explains nature, cause and effect of inflationary and deflationary
tendencies in the economy.
5. Theory of Economic Growth
Macroeconomic studies the theory of economic growth. It also explains various issues
relating to economic growth and development like privatization, economic liberalization,
balanced development, and poverty and inequalities reduction.
6. Trade Cycle
Macroeconomics deals with various theories relating to business fluctuations. These
business fluctuations are also known as business cycle or trade cycle. The theory of trade

2
 cycle deals with different phases of trade cycle like prosperity, recession, depression and
recovery. Similarly it explains the measures of controlling trade cycles.

Uses / Importance / Significance of Macroeconomics

The uses or importance of macroeconomics can be explained below:
1. Public Policy Formulation
Macroeconomics deals with the major economic issues and problems of an economy.
Macroeconomics is useful for formulation and execution of government policies. The
main concern of government is with the people. Hence, the attention of the government
is focused on general price level, production, volume of trade and so on. The study of
macroeconomic variables is important to formulate sound public policies.
2. To Understand General Unemployment
The use of macroeconomics is useful to solve complex economic problems of the
economy. The cause and effects and remedies of general unemployment can be understood
through the study of macroeconomics.
3. To Evaluate the Performance of the Economy
It is useful to evaluate the performance of the economy based on national income. On the
basis of the analysis of national income, we can say whether the economy is performing
well or not. We can say about the contribution of different sectors to national income.
4. To Understand Trade Cycle
There was great depression during 1930's. This drew the attention of economists towards
trade cycle. The trade cycle covers whole part of the economy. Hence it falls within the
scope of macroeconomics. Macroeconomics helps to understand the causes of upswing
and downswing, and helps to formulate the strategy to check them.
5. To Formulate the Strategy of Economic Growth
The study of economic growth falls within the scope of macroeconomics. The capacity
and source of the economy can be found out from macroeconomics. The strategy to
increase production, income, investment and employment to encourage economic
growth can be equipped.
6. To Understand the Working of the Economy
The study of macroeconomics is indispensable for understanding the working of the
economy because the economy as a whole is concerned with income, output and
employment. These variables are statistically measurable. Hence, it is easier to analyze
the functioning of the economy.
7. Useful in Business Decision-making
Macroeconomics is also useful in making business decisions. The knowledge of aggregate
demand and supply helps in production and pricing decisions. The macroeconomic
policies like fiscal policy and monetary policy have deep effects on business activities.
For example, tight monetary policy and high tax hurts the business expansion.

3
 8. Development of Microeconomic Theories
The study of macroeconomics is useful even for the purpose of building and developing
microeconomic theories. The determination of wage in an industry will be influenced by
the general wage rate of the economy. Similarly, the price of a commodity will also be
influenced by the prevailing general price level in the economy. In the situations of
inflation, generally the prices will increase, while in the years of depression the prices
will go down. Thus, no microeconomic laws can be formulated without a pre-study of
macroeconomics.
9. International Comparison
Macroeconomics provides necessary information for international comparisons. For
example, a comparative study of average national income, consumption and saving
between different countries requires macroeconomic information.

Importance / Uses of Macroeconomics in Business Decisions

The concept of macroeconomics can be used in making business decisions. The process of
applying macroeconomic theories in business decisions can be explained below:

To Estimate Output on the basis of

General Economic Trend

Importance of To Make Effective Decisions Regarding

Macroeconomics International Trade

To Determine the Social Responsibility

of the Firm

1. To Estimate Output on the basis of General Economic Trend

There are various issues that are related to the trends in macro variables, e.g. the general
trend in the economic activities of the country, investment climate, trends in output and
employment and price trends. These factors not only determine the prospect of private
business, but also greatly influence the functioning of individual firms. Therefore, a firm
planning to set up a new unit or to expand its existing size would like to ask itself - what
is the general trend in the economy? What would be the consumption pattern of the
society? Will it be profitable to expand the business? Answer to these questions and alike
are found through macroeconomic studies.
2. To Make Effective Decisions Regarding International Trade
An economy is also affected by its trade relations with other countries, so the firms deal
with exports and imports. Fluctuations in the international market, exchange rate, and
inflows and outflows of capital in an open economy have a serious bearing on its
economic environment and thereby, on the functioning of its business undertakings. The
managers of a firm would, therefore, be interested in knowing the trends of international
trade, prices, exchange rates, and prospects in the international market. Answer to such
problems is obtained through the study of trends in international trade, balance of
payment, foreign direct investment policy, trade policy and international monetary
mechanism.

4
 3. To Determine the Social Responsibility of the Firm
The government policies designed to control and regulate the economic activities of the
people affect the functioning of the private business undertakings. Besides, the firms'
activities as producers and their attempt to maximize gains (or profits) lead to
considerable social costs, in terms of environmental pollution, etc. Such social costs not
only bring firm's interest in conflict with that of the society, but also impose a social
responsibility on the firms. The government policies and its various regulatory measures
are designed, by large, to minimize such conflicts. Managers should be therefore fully
aware of the aspirations of the people and give such factors a due consideration in their
decisions. The economic concepts and tools of analysis help in determining such costs
and benefits.

Limitations of Macroeconomics
The significance of the study of macroeconomics remarkably increased after it was developed
and popularized by J.M Keynes. However, macroeconomics has following limitations:

Danger of Excessive Thinking in Terms of Aggregates

Aggregate Tendency May Not Affect All Sectors Equally

Limitations of
Macroeconomics
Indicates no Change has occurred

Fallacy of Composition

1. Danger of Excessive Thinking in Terms of Aggregates

The aggregates which are homogeneous in nature can lead to accurate results. There is
danger of excessive thinking in terms of aggregates which are not homogeneous.
Individual units possess individualistic features. They are non-homogeneous in
character. We cannot add up two books and three pens to make any meaningful
aggregate.
2. Aggregate Tendency May Not Affect All Sectors Equally
The limitation of macroeconomics is that aggregate tendency may not affect all sectors
equally. For example, the general increase in price affects different sections of the
community or the different sectors of the economy differently. The increase in general
level of price benefits the producers, but hurts the consumers.
3. Indicates no Change has occurred
The study of aggregates makes us believe that no change has occurred even if there is a
change. It indicates that there is no need of new policy. For example, a 5 percent fall in
agricultural price and 5 percent rise in industrial prices does not affect the price level. In
this situation, one may advise the government to make no change in policy because
general price level is the same. But in reality, the government needs to implement an
appropriate policy for supporting the farmers.

5
 4. Fallacy of Composition
The aggregate economic behavior is the sum of individual behavior. This is called fallacy
of composition. What is true in case of an individual may not be true in the case of
economy as a whole. For example, individual saving is a virtue; whereas aggregate
saving is vice. According to K.E. Boulding "These difficulties are aggregative paradoxes
which are true when used to one person, but false when used to the economy as a whole."

Relationship between Macroeconomics and Economic Environment for

Business: Macroeconomics and Business Environment
There are certain factors which constitute economic environment of a country. For example,
type of economic system, trends in national income, prices, saving, investment, financial
institutions, magnitude of foreign trade, political environment, and social system, degree of
globalization and influence of multinational companies. These factors have effects on the
performance of business firms. Thus business firms have to consider these factors in the
process of decision making. The major macroeconomic or environmental issues that come in
business decision making are explained below:
a. To Study the Nature and Trend of Domestic Business Environment
There are various issues related to macroeconomic variables such as trend of economic
activities, trend of investment, trends in output, employment and prices. These factors
determine the prospects of private business as well as they affect the smooth functioning
of individuals firms.
b. To Study the Trends of International Business
Fluctuations in the international market, exchange rate, inflow and outflow of capital,
exports and imports etc. have influence on domestic business environment. Business
firms are interested in knowing the trends in international trade, prices, exchange rates
and prospects in the international trade.
c. To Examine the Nature and Extent of Externalities of Business Environment
The various policies designed by the government to control the economic activities of the
people affect the functioning of business firms. The business firms in the modern world
are responsible to control the negative externalities and promote positive externalities.
d. To Examine the Role of Government Policies
Various macroeconomic policies like fiscal policy and monetary policy are implemented
by the government in order to achieve economic goals and regulate and promote private
sector. Macroeconomics plays a vital role in examining the role and effect of these
government policies.
e. Formulation and Implementation of Business Strategies
Macroeconomic concepts of inflation, exchange rate, trade policies etc. are important to
study and analyze the competitive advantage of business firm. Hence, macroeconomics
helps business firms to formulate and implement strategies in an effective way.

6
Circular Flow of Income and Expenditure in an Economy
Circular flow of income and expenditure is defined as the flow of payments and receipts for
goods and services, and factor services between different sectors of an economy. Circular flow
of income and expenditure shows the equality of income and expenditure in an economy.
Similarly, it helps to understand the economic interdependence among various sectors of an
economy. The circular flow consists of two flows-monetary flow and real flow. Real flow
consists of flow of goods and services as well as factors, whereas money flow comprises flow
of money income.

A. Circular Flow of Income and Expenditure in a Closed Economy

Closed economy is an economy in which there is no presence of international trade.
1. Circular Flow in a Two–sector Economy
The two sector economy consists of two sectors – household and business sector. Business
sector represents firms or producers which hire factor services like land, labor, capital
and organization to produce goods and services. Household sector represents the owners
of factors of production which are involved in consumption of goods and services
produced by the business sector. In this way firms and household are in twin demand
and supply relationship with each other.
Money payments
(R, w, i, )

Factors services
(N, L, K, O)

Household Business
Sector Sector

Goods &
services

Money payments
for goods and services

The above circular flow of two sector economy is based upon the following assumptions:
i. There are two sectors in an economy-households and business sector.
ii. It is closed economy with no exports and imports.
iii. There is no government.
iv. Whole money income is spent.
v. Households are the owners of factors of production.
vi. Firms employ factor services.
The flow chart is divided into two parts, the upper half and the lower half. The upper
portion shows the factor market and the lower portion shows product market. The
household sector provides factor services in the form of land (N), labor (L), capital (K),
and organization (O) to the business sector. This represents real flow of factors from

7
 household to business sector. In return they earn money receipts in the form of rent (R),
wages (w), interest (i) and profit () from business sector. This represents monetary flow
from business sector to household sector. The business sector produces goods and
services and supplies to the households sector which is real flow. The household sectors
make payment for the consumption of goods to the business sector representing
monetary flow. The important feature of circular flow in that factor payments are equal
to factor incomes and household expenditure is equal to the value of output.
If we relax the assumption of no savings, the amount of saving does not come into
consumption expenditure i.e. it works as a leakage and this leakage is converted into
investment (injection) through financial intermediaries.
2. Circular Flow of Income and Expenditure in a Three–sector Economy
The circular flow in three sector economy consists of the following assumptions:
i. There are three sectors in an economy: household, business and government sectors.
ii. It is a closed economy with no exports and imports.
iii. Households are the owners of factors of production and business sector uses factor
services in order to produce goods and services.

Saving Investment
Financial Intermediaries

Factor Services

Factor payments (R + w + i + )

Direct taxes on
Wages, salaries & Business income
Transfer payments
Indirect tax

Household Direct tax Government Business

Sector On income Sector Sector

Government purchase &

Subsidies (G)

Consumption Expenditure (C)

Household saving = Investment (I)

Goods and Services

The above circular flow represents a closed economy with three sectors. In the upper
loop, individuals are paid for factor services and government receives indirect taxes from
goods and services. Individuals use their income / factor payments received from
business and government sector to consume, save and pay direct tax to the government.
Government spends tax receipts, individuals lend their saving to the business sector
which invests in plants and equipment. In the lower loop, the spending flow includes
consumption (C), investment (I) and government expenditure (G). Similarly the real flow
of goods and services from business sector to household sector is also shown.

8
B. Circular Flow in a Four–sector Open Economy
The four sector model is derived by adding foreign sector in the three sector model. The four
sector model requires the following assumptions:
1. There are four sectors in an economy-household, business, government and foreign
sectors.
2. It is an open economy.
3. The external sector includes exports and imports of goods and services produced by the
firms.
4. The household sector exports only labor and capital.
Government purchase
And subsidies
Government
Net tax payments
Wages, interest, profit, rent

Factor Services

Household Saving Financial Investment Business

Sector Market Firms

Sale of goods and services

Consumption expenditure

Foreign Remittances
Foreign
Sector
Export of capital Payment for
And manpower imports (M)

In the above circular flow, the lower position of the bottom flow shows circular flow of money
in respect to foreign trade. Export as an injection to the economy makes goods and services flow
out of the country and make money flow into the country in the form of export earnings.
Similarly imports as the withdrawals from the circular flow make flow of goods and services
and flow of foreign exchange out of the country. Another flow is generated by the export of
factor services. The export of these services brings in factor payments in the form of foreign
remittance. These inflows and outflows go on continuously so long as there is foreign trade.
Individuals are paid for factor services and government receives indirect tax from goods and
services. Individuals use their income / factor payments received from business and
government sector to consume, save and pay direct tax to the government. Government spends
tax receipts, individuals lend their saving to the business sector which invest in plants and
equipment. The spending flow includes consumption (C), Investment (I) and Government
Expenditure (G). Similarly the real flow of goods and services from business sector to household
sector is also shown.