Macro Economics Notes

Steve Ouma Oyugi 2nd Year 2nd Semester

Macro Economics

Kimathi University College of Technology

Macroeconomics

1. Theory of income, output and

employment. The elements herein are: Theory of consumption function Theory of investment function Theory of business cycle Theory of prices prices whose elements 2. are: Inflation Deflation Reflation Stagflation 3. Theory of Economic Growth 4. Macro theory theory of Economic Economic Growth Growth

The Relationship between Macro and Microeconomics

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Microeconomics deals with the behavior of individuals, consumers, factor owners, firms, individual industries and individual markets.

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Macroeconomics on the other hand deals with a holistic approach of the economy by dealing with various aggregates, which include: 1. 2. 3. 4.

Tota Totall empl employ oyee ees s Nati Nation onal al inc incom ome e Genera Generall pric price e leve levels ls Infl Inflat atio ion n e.t.c e.t.c..

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These elements are explained further as:

Macroeconomics tries to explain what determines the level of total National Economic activity and what causes economic growth.

Employments and unemployment There are several causes of unemployment and involuntary unemployment. They include:

The classical economists had the basic principle that the economy had self -adjusting mechanisms to remain at full employment. This was based on the JB Say laws of the market, which says that demand creates its own supply.

British Economist JM Keynes (1883 – 1946) showed that an existence of great and involuntary unemployment during the depression of 1930 created the grounds on which macroeconomics is founded. Central issues in Macroeconomics Macroeconomics deals with the following studies, which makes up its scope: Steve Ouma Oyugi

Macro Economics

1.

National income/Gross National Product – this is the total value of all final goods and services produced in a country within a year. It determines per capita income, also determined by the level of physical capital, human capital and technology. 2. General price level and inflation – The classical economists argued that inflation and prices was determined by the amount of money in circulation. Keynes introduced the demand pool theory of inflation caused by excessive demand as can happen during boom 7th July 2010

or panic buying. 3. Other causes causes of inflation inflation could could be cost push inflation. 4. Economic growth – this is sustained growth in national incomes. Keynes concentrated mainly on short-term growth but we know that economic growth is a function of levels of investment. A certain level of economic growth is needed to sustain a steady growth as explained by growth models. 5. Stagflation – this is a special form of inflation resulting from the supply side constraints. The Keynesian economy focuses mainly on demand side constraints, but modern macroeconomists reveal supply side constraints, which can come from supply shocks. 6. Balance of payments (BOP) and [Exchange rates] - this is an analysis of transactions of the residents of a country with the rest of the world within a certain period. It takes account of imports, exports and capital exchange leading to either supply or deficits. Exchange rate is the rate at which a country’s currency exchanges with another’s currency. A microeconomic approach has limitations to the extent that there it creates self confusing paradoxes. A firm will make more profits by cutting wages and thus maximizing profits. This, when looked at from a macroeconomics view reduces aggregate demand.



Macro Economics


3. An aggreg aggregative ative tendency tendency does not influence all sectors of the economy in the same way thus precaution has to be taken incase it happens. E.g. some industries may benefit more than others with an increase in the general price level. 4. Macro-analy Macro-analysis sis is fruitful fruitful when when aggregate variables are accurately measured. However even with an advanced statistical procedure, desirable accuracy in the measurement of macro-economic variables is not possible e.g. it is not easy to accurately measure the national income of an economy.

Savings An individual or a firms saving is encouraged but at a micro economic level may lead to a fall in the national income. Macroeconomic approach helps formulate government macro policies and thus accelerating economic growth. Extra work Advantages of Macroeconomics 1. Formul Formulati ation on and and executi execution on of economic policies by the government. 2. Indisp Indispens ensabl able e for the the study study of macroeconomics, which is necessary for studying the vast fields of factor generalizations. 3. Indisp Indispens ensabl able e for the the study study of microeconomics. No laws of microeconomics can be formulated unless pre-study of the aggregates bearing on it have been made. 4. Indisp Indispens ensabl able e for the the study study of aggregate values. There is a clear difference between individual and group behavior and as such what is applicable to a firm may not be true for the whole economy. 5. Indisp Indispens ensabl able e for guidi guiding ng governments. Disadvantage of Macroeconomics 1. The study study of of individu individual al units units in some cases is very important and as such microeconomics is implemented instead. 2. Macroecono Macroeconomics mics is applicable applicable in studying homogeneous aggregate variables only, and as such cant be applied in the context of heterogeneous variables. Steve Ouma Oyugi

National Income and National Income Accounting National income is the total market value of all goods and services produced produced within the economy within a year. National income is a monetary measure and takes account of final goods without intermediaries.

government (G). 4. Net Net expo export rts s (X-M (X-M). ). Y=C+I+G+(X-M) 5. Net fact factor or incom income e which which the the difference between net factor incomes such as wages.

Gross Domestic Product This is the monetary value of goods and services produced by the normal residents and non-residents of a country less the net factor incomes earned abroad. GDP = GNP – NFI

Note that net factor income is different from net exports and imports and thus don’t form part of GNP or GDP. Net National Product This is the market value of all final goods and services after providing for depreciation. NNP = GNP – Depreciation

National Income = National Expenditure = National Product

Gross National Product This refers to the value of goods and services produced by the residents of a country, whether locals or foreigners. This constitutes:

Macro Economics

1. Value Value of good goods s and serv service ices s produced and consumed by the consumers (C). 2. New capita capitall goods goods plus plus invento inventories, ries, not sold during a year (I). 3. Goods Goods and and servic services es from from the the 7th July 2010

National Income and Factor Cost ; these take into account indirect taxes and subsidies. The difference between total and direct taxes and subsidies is referred to as Net Indirect taxes. NI (factor cost) = Net National Product – Indirect taxes + subsidies.

Circular Flow of Income This is a very simple model showing the working of the economy, depicting movements of resources between the Kimathi University College of Technology


Macro Economics


producers and consumers. It shows how income moves from one sector of the economy to another in a series of monetary movements.

Two-Sector Model of Circular Flow of Income (Closed Economy) In a simple microeconomic model, we assume that there is no government intervention and no foreign trade. In this case, the value of the Output Y Produced = the value of Output sold.

Savings = Investments

Three Sector Model of Circular Flow of Income (Open Model) In this model, the government is included. The intervention of the government involves: i) Taxation ii) Government Expendit ur ure i i i) Government B or orrowing

QuickTimeª and a BMP decompressor are needed to see this picture.

National Income Identity in a 4 Sector Model In a 4-sector model, we introduce trade but we assume that it is only the business firms that interact with the foreign countries. 4 sector Models


Identities 1. Y = C + I C-Consumption Expenditure I - Investments What happens to produced income which is not consumed? It is used to increase the inventories, which is treated as actual investments or savings.

Identities The National Income Identity = Total expenditure 1. Y = C + I + G Total income consumed, saved and taxed. 2. Y = C + S + T Since;

2. Y = C + S Putting equations 1 and 2 together produces: C+I=C+S I=S NB: - In a simple two sector model where there is no government intervention or foreign trade; Steve Ouma Oyugi

deficit. If the government expenditure exceeds the tax collected, then there would be a budget deficit. To finance this deficit, the government borrows from the financial market and this reduces private investment hence government borrowing crowds out private investment.

Y= E (Expenditure)

Macro Economics

3. C + I + G = C + S + T 4. G - T (Defi (Deficit cit/Su /Surpl rplus) us) = S - I Equation 4 explains the government budget 7th July 2010

NI Identity 1. Y = C + I + G + (X - M) Where (X - M) = Xn 2. Y = C + I + G + Xn But Y = C + S + T Thus 3. I + G + Xn = S + T The meaning of equation 3 is that the total private investments + government expenditure + net export = savings + Net Kimathi University College of Technology


Macro Economics

Revenue

Measuring the National Income Ways; 1. Valu Value e added added metho method d This divides the economy into sectors such as fishing, mining, agriculture, transport, industry, manufacturing e.t.c. We then calculate the net value added by each sector at factor cost and market price. In order to obtain the net value, we subtract the cost of intermediaries (raw materials used to produce the end product, capital depreciation) but add the net factor income from abroad. NB: - NI or Net National Product = NDP (fc) + NFI. Where fc means at factor cost. Significance of the value added method The method reveals the performance of the sector. Precautions to take when using the value added method The value of self occupied houses should be included. •

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2nd hand goods are excluded Production for self consumption should be included Services from housewives is normally omitted due to complications that arise in computation.

2. Income Income metho method d The NI is obtained by summing up the incomes of all individuals of a country. This constitutes rent from Steve Ouma Oyugi

Macro Economics


land, interest on capital, wages and salaries and profits from entrepreneurs.

3. Expen Expendit diture ure method method Involves adding up all the expenditures made on goods and services within 1 year. This expenditure is on the consumer goods and services by individuals and households denoted by (C), the government expenditure denoted as (G), expenditure on the capital goods and inventories denoted as (I) and Net Export Expenditure denoted at (X - M) where (X - M) is Xn. GDP = C + I + G + Xn.

Difficulties in measuring National Income Treatment of non-monetary transactions e.g. housewives services and household consumption. Treatment of government activities like defense, social services like free education and medication. Activities of foreign firms and profit repatriation. NB: - Income from foreign firms is introduced and treated as National Income yet we know that it ends up back in their countries. Lack of accurate record keeping particularly by the households. Lack of specialization by household. •

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of Welfare The GDP should factor in the number of working hours and the conditions therein. GDP ignores non-monetary services. GDP should measure the levels of environmental degradation and the pollution and should factor in the cost of rehabilitation and reclamation. GDP does not take into consideration the distribution of national incomes and its usage e.g. expenditure on war and national security budget. •

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The Aggregation of the Economy Product Market Labour Market Money Market Bonds and Equities Market

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The economy is divided into the above four sectors.

Product Market The equilibrium in the product market is achieved when output = demand.

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Limitations of GDP as a Measure 7th July 2010

Y = C + I + G + (X - M) C in our analysis

Keynesian Model of National Income Determination Income and Expenditure Approach The Keynesian is a short-term approach, which assumes that the price level in the Kimathi University College of Technology


Macro Economics


economy remains unchanged. Keynes also assumes that the stock of capital, techniques of productions and labor efficiency remain unchanged. In his model, income is a function of the level of employment since labor is the only variable factor. The level of employment is determined by aggregate supply and demand.

Keynes assumes that investment is autonomous and does not change with the changing levels of income.



Consumption Demand This depends on the marginal propensity to consume and the level of National income.

Take note that C + I is parallel to C = a + bY, indicating that the level of investment is constant and does not depend on change in income.


OZ is the income line The point beyond E represents savings of the community, given by the identity Y = C + S.

Aggregate Supply The short run level of National Income depends on Aggregate supply and demand. Aggregate supply is composed of consumer goods and services as well as capital goods. Keynes assumed unchanging capital stock and level of technology, with labor being the only variable factor.

Investment Demand This is a component of aggregate demand determined by: 1. Margin Marginal al efficie efficiency ncy of capit capital al (Expected Rates of Profits) 2. Rate Rate of of int inter eres estt Steve Ouma Oyugi

Macro Economics

Keynes Criticism of Classical Economists

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The classical economists assumed that the equilibrium level of National Income is established at full employment and the economy always tends towards full employment through self adjusting mechanisms. Assuming a state of employment, corresponding to OYF level of National Income but according to Keynes, equilibrium is established at level E, which corresponds to OY level of National Income. This causes a level of unemployment. For full employment to be achieved, investment demand must equal RH, but at E it is only equal to EQ, therefore full employment is not always guaranteed. Full employment is not always guaranteed because there are savers and they not necessarily invest their money. Investment in most instances is undertaken by Entrepreneurs. There may also be several other reasons for saving such as to provide for education and contingencies, holidays and even at old age Kimathi University College of Technology


Macro Economics


and retirement. Therefore savings may not be equal to investments, this results to a level of unemployment. The level of investment depends upon the marginal efficiency of Capital, which is the main motivation for investment. i.e. if the expected rates of profits are not favorable, then people are not able to invest.

Keynes Analysis of a 2 Sector Model (Keynesian Multipliers) We assume that there isn’t government taxation and expenditure and we are dealing with a closed economy. National Income Consumption Investment

Y=C+I C = a + bY I = Ia (Investment is autonomous)

Savings Investment Approach Y = C + S C=Y–S Y = Y – S + I Thus; S=I But Y = C + I; thus I = Y – C Yet C = a + bY There Therefor fore: e: - Howeve However, r, to to obtai obtain n Y = (I (I + a)/(1-b) C=Y–S then since S=I from iii a + bY = Y – S I=Y – a - bY Thus Y=I + a + bY S = Y – a – bY = -a + Y – bY = -a + Y(1 – b) 1 – b is the marginal propensity to save. If the level of savings is very high then the level of multiplier increases too.

Thus; Y = (a + bY) + Ia Y = a + bY + Ia Y – bY = a + Ia Y(1 – b) = a + Ia Y = (a + Ia)/(1-b) Thus; Y = [1/(1-b)]a+Ia

Relevance of Keynesian Analysis in Respect to Developing Countries Keynes put forward a theory of income and employment, which explains the determination of income and employment through the aggregate demand and supply. ***Keynes, at a time of economic depression (1930’s) in Europe, where the level of aggregate demand was the main cause of unemployment

Nb: - An increase in b leads to an increase in Y Equation iii shows the equilibrium level of occurring where Aggregate Demand is equal to aggregate supply. The level of equilibrium Y can be obtained by multiplying the autonomous investment by the multiplier. The higher the marginal propensity to consume the higher the level of income. Steve Ouma Oyugi

in developing economies, poverty and unemployment result from lack of capital, relative to labor availability. Thus in developing nations, there is supply side constraint resulting from lack of capital

Macro Economics

7th July 2010

and means of production. Keynes proposed such measures as increased government expenditure as a remedy for Europe. If this is applied in developing countries it is going to be inflationary. Dr. R. V. Rao ascertains that the Keynesian multiplier is inapplicable in underdeveloped/developing economies since it will lead in a rise in prices. This is because the supply curve of output is relatively inelastic, therefore rising demand would lead to inflation. Application of Consumption Function Aggregate demand and supply cannot fully explain full employment and for employment to exist savings must equal investments failure to which we experience involuntary unemployment. Marginal propensity to consume explains the consumption changes. Consumption changes at a lower rate than increase in income. In order to maintain a certain level of income and employment the gap between income and consumption should be matched by investment to prevent unemployment. It is important in understanding the multiplier since the size of the multiplier depends on the marginal propensity to consume. Entrepreneurs base their investments on the marginal efficiency of capital, which is determined by current levels of consumption. Consumption function explains business cycles since marginal propensity takes the form 0
Leakages in a multiplier Kimathi University College of Technology


Macro Economics

An investments results to an increase in income by the value of the multiplier. However, income doesn’t increase indefinitely since the marginal propensity to consume is less than one due to the following leakages; Savings Debt payment Precautionary and speculatory motives of holding cash balances Importation – increase income in foreign countries Taxation Inflation


This does not change with income, and this kind of expenditure would include government investment in roads.

Induced Investment This is investment that is affected by changes in the level of income.

The theory of the multiplier is one of the greatest contributions of J. M. Keynes. It explains the effect of investments in an economy and can be used to explain the effect of investments in an economy and can be sued to explain trade cycles of boom and depression. It normally applied by the government in its physical policy to move the economy from depression or to check inflation and unemployment through expansionary and contractionary fiscal policies.

Investment (This is an increase in the stock of capital) Investment is new expenditure incurred on addition of physical stock of capital e.g. machinery, plant, equipment, tools and inventory. This should be differentiated from financial investment, which involves trading in shares, stocks and bonds, which is simply the transfer of ownership.

Steve Ouma Oyugi

C is the supply price of the cost of capital R is the annual expected yields of investments r is the expected rates of return of profits. Investment Demand QuickTimeª and a BMP decompressor are needed to see this picture.

It depends upon the marginal efficiency of capital, or the expected rates of profits. It is also affected by the rates of interest. For an investment choice to be made, it must be expected to fetch higher returns than the current market rate of interest. Marginal efficiency of capital in reality is a higher inducement for investment since the market rate of interest is ‘sticky’. Interest on the other hand is determined by liquidity preference and money supply. The greater the liquidity preference the higher the interest rate and the greater the money supply the lower is the interest rate.

Marginal efficiency of capital

Autonomous Investment Macro Economics

This is the rate of profits expected from an extra unit of capital asset. This is determined by(depends on) the supply price or the cost of capital and also depends on expected yields of investments.

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Equilibrium level of investment is attained where the marginal efficiency of capital is equal to the current rates of interest. The marginal efficiency thus represents investments. Economic depression is a signal of expected marginal efficiency of capital hence low investment demand.

Marginal efficiency of capital (shift outwards) Increase in demand for products leads to change in level of investments Change in technology and efficiency User cost of capital (this determines •

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Steve Ouma Oyugi 2nd Year 2nd Semester • •

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Macro Economics

the rate of return on capital) Credit availability Government fiscal policy (government borrowing crowds out private investment) Government expenditure on infrastructure, communication, roads and security affects the levels of investment.


more due to change in income from Yt-1 to Yt. This means that investment is also a function of a change in income.

Accelerator Principle on Investments Post Keynesian economists argue that investments is also a function of income since an increase in income increases consumption. Increased consumption causes increased investments by a multiple amount. Investment is therefore induced by changes in income or consumption. To produce a certain amount of output one requires a certain amount of capital, and this amount at time t, gives a certain amount of income at time t. Kt is the stock of capital at time t, and Yt is the level of output at time t, and V is the capital output of ratio.

An increase in income from Y(t – 1 ) (previous period) to Yt increases the stock of capital from K(t-1) to Kt. The change in the stock of capital between t-1 and t would be given by [Kt – K(t-1)] (Investment) = VYt – VY (t-1)

Money

I = V(Yt – Y(t-1) Investment will increase three times more due to change in income, thus V represents the value of the accelerator. If V = 3, then it means that investment changes 3 times Steve Ouma Oyugi

Macro Economics

7th July 2010


Macro Economics Notes

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