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1. Steve Ouma Oyugi Macro Economics Kimathi University College of Technology 2nd Year 2nd Semester
Steve Ouma Oyugi Macro Economics 7th
July 2010 Kimathi University College of Technology
Macroeconomics
The Relationship between Macro and Microeconomics
Microeconomics deals with the behavior of individuals,
consumers, factor owners, firms, individual industries and
individual markets.
Macroeconomics on the other hand deals with a holistic
approach of the economy by dealing with various aggregates,
which include:
1. Total employees
2. National income
3. General price levels
4. Inflation e.t.c.
Macroeconomics tries to explain what determines the level of
total National Economic activity and what causes economic
growth.
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:
1. Theory of income, output and employment. The
elements herein are:
 Theory of consumption function
 Theory of investment function
 Theory of business cycle
2. Theory of prices whose elements are:
 Inflation
 Deflation
 Reflation
 Stagflation
3. Theory of Economic Growth
4. Macro theory of Economic Growth
These elements are explained further as:
Employments and unemployment
There are several causes of unemployment and involuntary
unemployment. They include:
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 or panic buying.
3. Other causes of inflation 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.
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. Formulation and execution of economic policies by
the government.
2. Indispensable for the study of macroeconomics,
which is necessary for studying the vast fields of
factor generalizations.
3. Indispensable for the study of microeconomics. No
laws of microeconomics can be formulated unless
pre-study of the aggregates bearing on it have been
made.
4. Indispensable for the 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. Indispensable for guiding governments.
Disadvantage of Macroeconomics
1. The study of individual units in some cases is very
important and as such microeconomics is
implemented instead.
2. Macroeconomics is applicable in studying
homogeneous aggregate variables only, and as
such cant be applied in the context of
heterogeneous variables.

2. Steve Ouma Oyugi Macro Economics Kimathi University College of Technology 2nd Year 2nd Semester
Steve Ouma Oyugi Macro Economics 7th
July 2010 Kimathi University College of Technology
3. An aggregative 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-analysis is fruitful 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.
National Income and National Income Accounting
National income is the total market value of all goods and
services produced within the economy within a year. National
income is a monetary measure and takes account of final
goods without intermediaries.
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:
1. Value of goods and services produced and
consumed by the consumers (C).
2. New capital goods plus inventories, not sold during
a year (I).
3. Goods and services from the government (G).
4. Net exports (X-M).
Y=C+I+G+(X-M)
5. Net factor income which 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 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
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.
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.
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;
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 Expenditure
iii) Government Borrowing
Identities
The National Income Identity = Total expenditure
1. Y = C + I + G

3. Steve Ouma Oyugi Macro Economics Kimathi University College of Technology 2nd Year 2nd Semester
Steve Ouma Oyugi Macro Economics 7th
July 2010 Kimathi University College of Technology
Total income consumed, saved and taxed.
2. Y = C + S + T
Since;
Y= E (Expenditure)
3. C + I + G = C + S + T
4. G - T (Deficit/Surplus) = S - I
Equation 4 explains the government budget 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.
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
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 Revenue
Measuring the National Income
Ways;
1. Value added method
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.
 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 method
The NI is obtained by summing up the incomes of
all individuals of a country. This constitutes rent
from land, interest on capital, wages and salaries
and profits from entrepreneurs.
3. Expenditure 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.
Limitations of GDP as a Measure 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.
The Aggregation of the Economy
 Product Market
 Labour Market
 Money Market
 Bonds and Equities Market

4. Steve Ouma Oyugi Macro Economics Kimathi University College of Technology 2nd Year 2nd Semester
Steve Ouma Oyugi Macro Economics 7th
July 2010 Kimathi University College of Technology
The economy is divided into the above four sectors.
Product Market
The equilibrium in the product market is achieved when
output = demand.
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 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.
Consumption Demand
This depends on the marginal propensity to consume and the
level of National income.
OZ is the income line
The point beyond E represents savings of the community,
given by the identity Y = C + S.
Investment Demand
This is a component of aggregate demand determined by:
1. Marginal efficiency of capital (Expected Rates of
Profits)
2. Rate of interest
Keynes assumes that investment is autonomous and does
not change with the changing levels of 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.
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.
Keynes Criticism of Classical Economists
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 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.

5. Steve Ouma Oyugi Macro Economics Kimathi University College of Technology 2nd Year 2nd Semester
Steve Ouma Oyugi Macro Economics 7th
July 2010 Kimathi University College of Technology
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 Y = C + I
Consumption C = a + bY
Investment I = Ia (Investment is
autonomous)
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
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.
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
Therefore: - However, to obtain Y = (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.
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
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 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<mpc<1. Marginal
propensity varies less than the change in income.
Leakages in a multiplier
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;
1. Savings
2. Debt payment
3. Precautionary and speculatory motives of holding
cash balances
4. Importation – increase income in foreign countries
5. Taxation
6. Inflation
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.
Autonomous Investment

6. Steve Ouma Oyugi Macro Economics Kimathi University College of Technology 2nd Year 2nd Semester
Steve Ouma Oyugi Macro Economics 7th
July 2010 Kimathi University College of Technology
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.
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
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.
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
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 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.
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)
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 more due to
change in income from Yt-1 to Yt.
This means that investment is also a function of a change in
income.

7. Steve Ouma Oyugi Macro Economics Kimathi University College of Technology 2nd Year 2nd Semester
Steve Ouma Oyugi Macro Economics 7th
July 2010 Kimathi University College of Technology
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