What is ‘macroeconomics’?
You may have already studied microeconomics, which
looks at supply, demand and prices for individual
goods. Macroeconomics looks at the bigger picture
and involves the study of the economy as a whole.
Let us start by looking at a simple example – a
‘two sector’ economy made up of households
(consumers) and firms (producers) -and use this to
develop the idea of national income. To start with
we will ignore the impact of government policy and
Households ultimately own the factors of
production, e.g., labour, materials and capital,
and supply these factors to firms who use them to
produce goods and services. In return households
earn rewards for supplying the firms with the
factors of production e.g., wages and interest on
capital. These rewards are in turn used to buy the
goods that the firms have produced. This process
is known as a circular flow- see Figure 1.
Figure 1: Simple circular flow
From Figure 1 we can see that there are three ways
of measuring the amount of economic activity in
the economy. These are:
(a)National product/output = the flow counted at
this point represents the amount received by firms
for their total production.
(b) National income = the flow counted at this
point represents the total income received in
return for factors of production.
(c) National expenditure = the flow counted at
this point represents the total expenditure by
households on goods and services.
If it is assumed that all income is spent, then
whichever method is used the same measure of
economic activity must be obtained. Let’s look at
a numerical illustration.
Assume there are two producers – a lumberjack and
a carpenter. The carpenter makes chairs each of
which needs £5 worth of wood and which he sells
for £20. Total annual sales are 10,000 chairs. The
income and expenditure accounts for the lumberjack
and carpenter are:
‘National Product’ = 200
This is the total value of the production (i.e.,
‘National Income’ = 40 + 20 + 50 + 40 + 10 + 5 +
20 + 15 = 200
This is the total received for factors of
production i.e., wages, interest, rent and profit
‘National Expenditure’ = 200
This is the total amount spent on production (i.e.
We can see that the three measures of economic
activity all give the same value.
Now we can start adding to this model to make it
more realistic. This model will use the following
Consumption (C) – consumption goods produced and
sold to customers i.e., the chairs.
Savings (S) – income that is not spent on
Investment (I) – production of, or expenditure
on, non-consumption goods (carried out by firms)
including expenditure on increasing stocks of
Injections – expenditure on domestic output not
originating from consumers e.g., investment.
Leakages – income not spent on consumption of
domestic output e.g., savings.
Consumers will not spend all their income on goods
and services. They will also have savings – income
not spent on consumption. Similarly producers will
not just spend on producing goods but will also
carry out investment – expenditure on
There are therefore injections into (investment)
and leakages from (savings) the circular flow.
These injections and leakages can now be added to
the circular flow model (see Figure 2)
Notes to Figure 2
In this model the income earned by households (Y)
must be equal to expenditure on purchasing
national product (E). Output of consumption goods
by firms equals consumption expenditure by
household’s (C). Note that households do not spend
all their income – instead they save (S) – a
leakage. Expenditure on non-consumption goods by
firms is investment (I) – an injection.
Income (Y) = Expenditure (E)
Income (Y) = Consumption + Saving (C + S)
Expenditure (E) = Consumption + Investment (C + I)
Therefore, if a constant level of economic
activity is to be maintained leakages will equal
In reality there are far more leakages and
injections than just savings and investments,
including government and overseas sectors, means
that we will need to take into account additional
leakages and injections.
Savings (S)Investment (I)
Taxes (T) – paid to the governmentGovernment
spending (G) – on goods and services
Imports (M) – amounts paid for goods and
services originating in other countriesExports
(X) – amounts received for goods and services
sold in other countries
As long as the various leakages are equal to the
injections, income will equal expenditure and the
economy will be in equilibrium. This is shown
graphically in Figure 3.
Keynesian view of national income determination
The level of national income in the economy is
determined by level of aggregate demand (AD).
Aggregate demand summarises the various sources of
demand for the output of an economy.
Aggregate demand (in a full economy) = C + I + G +
X – M
C= private sector consumption demand
I= private sector investment demand
G= government expenditure
X= export demand (i.e., demand from overseas for
the national output)
M= demand for imports
Note that C, I and G may include demand for
imported goods. However, imports are not part of
the national output and are therefore deducted in
calculating aggregate demand. In our earlier
simple two-sector economy example with no
government or overseas sectors, aggregate demand
would have been C + I.
As we saw earlier not all income is automatically
used for consumption. The Keynesian view is that
consumption demand is a function of the level of
national income, expressed by the consumption
C = a + cY
C= desired consumption (backed up by purchasing
a= part of desired consumption which is
independent of income level
c = ‘marginal propensity to consume’ – the
proportion of each additional £1 of income which
people wish to spend on consumption
Y= national income
Thus people’s expenditure levels depend on their
income. As income rises expenditure rises but not
all of the extra income is spent. The consumption
function may be plotted as shown in Figure 4.
Figure 4: the consumption function
As income rises so does desired consumption. The
marginal propensity to consume, c, is the slope of
the line. Where there is a circular flow of funds
expenditure equals income, giving the 45-degree
line shown in Figure 3 (when the axes are on the
same scale). This shows national output.
Equilibrium within the economy occurs where
aggregate demand is satisfied by national output.
See Figure 5.
Figure 5: National income determination
Notes to Figure 5
A represents a point at which aggregate demand is
not satisfied by national output. Producers will
increase output to meet demand and equilibrium at
point Y will be reached.
B represents a point at which aggregate demand is
below national output so producers will have
excess stocks so they will cut production and
equilibrium at point Y will be reached.
The idea of the economy reaching an equilibrium
point is vital to the two main schools of thought
regarding macroeconomics which students are
expected to understand for the paper 4 examination
- monetarist and Keynesian.
The Monetarist view is that there is only one true
equilibrium point for the economy and that this
will be at full employment. Equilibrium will occur
when supply equals demand in all markets. For
labour this means that anyone who wants a job can
have one. Monetarists believe that the economy
will automatically gravitate towards this
equilibrium unless this is prevented by market
imperfections. Thus, the role of government is to
‘free up’ the economy by removing these
imperfections. Once this is done the role of
government becomes minimal.
The market imperfections that need to be overcome
(a) Inflation, because it distorts the price
(b) Government spending and taxation – ideally
government spending will equal taxation so that
government injections and leakages have no net
(c) Price fixing and minimum wages that distort
the market for goods and services;
(d) Regulation of markets;
(e) Abuses of monopoly power.
Keynesian theory is that the economy can be in
equilibrium at many different times – not
necessarily at just full employment. Under this
view governments can act to move the economy to a
“better” equilibrium. Keynes argued that the
equilibrium position is determined by the total
demand for a country’s goods and services
(“aggregate demand“) and thus the role of
government was to manipulate aggregate demand to
achieve policy aims.
Various governments have followed one or other of
the approaches over the years. Obviously you will
not be required to discuss the economic history of
the UK or any other country in the examination you
will be expected to be able to discuss these
theories in the examination and reference to real
life examples is sometimes helpful to illustrate
Since World War Two governments have adopted four
central objectives for their macroeconomic policy.
Achieving economic growth – increasing supply
and demand in the economy as a whole;
Price stability – ensuring that general price
levels do not increase because of inflation;
Full employment – ensuring that everyone has a
job if s/he wants one;
Balanced balance of payments – managing
relationships and trade with other countries.
Not all governments place the same emphasis on
each of the four objectives but they feature in
varying degrees of importance in all economic
policies. For the remainder of this article we
will look at why these areas are so important and
briefly review the problems faced by governments
in formulating their macroeconomic policy.
Most governments aim to achieve economic growth.
Growth should result in an increase in the goods
and services being produced which in turn allows
people to earn more. Economic growth should allow
more people to find work and, in the right
circumstances, lead to an improved standard of
living. There is also the potential for an
improved balance of trade as increased production
is available for export and the level of demand
for imported goods decreases.
However, growth can bring with it problems and
challenges. A country needs to achieve economic
growth per head of population rather than just in
total terms. If, for example, a country’s economy
is growing by 5% per annum but the population is
growing by 6% then the per capita economic wealth
of the country is actually declining. This is a
particular problem in developing countries where
population growth rates remain high. Governments
also need to take into consideration the type of
growth being achieved and the impact this may be
having on the country and its population. The
growth achieved at the cost of high levels of
pollution or through the exploitation of the poor
will be bad for the country in the longer term. A
government needs to consider the distribution of
the gains from economic growth among the
population. The gap between rich and poor will
widen if gains are not shared out fairly and the
government will need to decide to what extent and
how to manage this process.
In basic terms inflation occurs when there is
excess demand which forces up prices and factor
prices. Most governments want stable prices and
low inflation. In the UK the fight against
inflation has been a mainstay of government policy
for many years. One of the main reasons given for
this is that inflation causes uncertainty as to
future values and therefore stifles investment and
prevents growth. Certain elements of society will
be badly effected by high levels of inflation
because not all incomes rise in line with it -
those on fixed incomes suffer the most. High
levels of inflation discourage saving because of
the declining value of the money saved. In extreme
cases the function of money may break down
resulting in civil unrest, as happened in Germany
in the 1920s, or even war. In addition Monetarists
consider that inflation distorts the working of
the price mechanism and is thus a market
imperfection preventing the economy reaching full
So governments will be aiming to achieve economic
growth while at the same time controlling
inflation at an acceptable level. However, there
are other elements to the macroeconomic balancing
act which need to be taken