Economics 6

The term 'Macro' in English language has its origin in the Greek language term 'Makros' which means 'Large.'
Macro economics, therefore, studying economic problems from the point of view of entire economy, e.g.,
aggregate consumption, aggregate employment, national income, general price-level, etc.
Definition
(i) In the words of Boulding, "Macro Economic Theory is (hot part of economics which studies the over all
averages and aggregates of the system."
(ii) According to Shapiro, "Macro Economics deals with the functioning of the economy as a whole."
(iii) In the words of Ackley Gardner, "Macro Economics concerns with such variables as the aggregate
volume of the output of an economy, with the extent to which its resources are employed, with the size of
national income and with the genera/ price- level."
(iv) According to M.H. Spencer, "Macro Economics is concerned with the economy as a whole or large
segments of It In macro economics, attention is focussed on such problems as the level of unemployment, the
rate of inflation, the nation's total output and other matters of economy-wide significance."
Scope of macro economics is the use of economic resources at the national level. These resources have their
effect on the national income, employment, effective demand, aggregate saving, aggregate investment, price-
level, economic development etc. of the country. Its scope can be divided into the following parts:
(i) Theory of National Income: Macro economics studies the concept of national income, its different
elements, methods of measurement and social accounting.
(ii) Theory of Employment: Macro economics also studies problems relating to employment and
unemployment. It studies different factors determining the level of employment, viz, effective demand,
aggregate supply, aggregate consumption, aggregate investment, aggregate saving, multiplier, etc.
(iii) Theory of Money: Changes in demand for, and supply of money have considerable effect on the level of
employment. Macro economics therefore, studies functions of money and theories relating to it. Banks and
other financial institutions are also part of its study.
(iv) Theory of General Price Level: Determination of and changes in general price-level are also studied under
macro economics. Problems concerning inflation or general rise in prices and deflation or general fall in prices
are also studied under macro economics.
(v) Theory of Economic Growth: Study of problems relating to economic growth or increase in per capita real
income forms part of macro economics. It studies the economic growth of under- developed economies.
Monetary and fiscal policies of the government are also studied therein.
Module C
MACROECONOMICS
Overview on Macroeconomics; Macroeconomic Goal, Policies and Accounts
Macroeconomic Accounts: National Income Account, Fiscal Account, Monetary Account
and BOP Account. Macroeconomic Policies and their Interactions
6.1 Macroeconomics
6.2 Scope of macro economics

PAPER 1: PRINCIPLES OF ECONOMICS AND BANGLADESH ECONOMY
(vi) Theory of International Trade: Macro economics also studies trade among different countries. Theory of
international trade, tariff, protection etc., are subjects of great significance to macro economics.
Since the publication of Lord Keynes' famous book "The Genera/ Theory of Employment, Interest and Money"
in 1936, the importance of the study of macro economics has increased manifold. The main uses of the study of
macro economics are as follows:
(1) Helpful In understanding the functioning of an Economy: Modem economy has become a very complex
affair. Several economic factors which are inter-dependent operate in it. To have an understanding of its
organisation and functioning one cannot depend on individual units alone. Study of economy as a whole, has
therefore, become very essential.
(2) Study of National Income: In modem times, it is the study of national income of almost every country that
enables us to know about the economic conditions of different countries of the world. While formulating its
policies concerning economic plans, welfare of the people and war, a country must have full knowledge of its
national income. It is possible through macro analysis alone.
(3) Formulation of Economic Policy: Study of macro economics is of great significance in formulating
economic policies. Almost all modem governments take resort to aggregate data pertaining to economic factors,
viz, national income, aggregate employment, aggregate investment, general price-level etc. in formulating
economic policies. In the words of Bouldlng, "From the view point of economic policy, macro economics is of
great relevance because economic policies of the government are more concerned with the group of individuals
than the individuals."
(4) Study of Trade Cycles: Trade Cycles or the problem of economic fluctuations is an economic problem of
great importance. In a capitalist economy, rapid economic changes take place. These changes have an adverse
affect on the economy. It is very essential to check them. These economic fluctuations or changes depend on
aggregate factors like aggregate saving, aggregate output, aggregate demand, aggregate supply etc. Study of
macro economics becomes imperative to know the causes responsible for trade cycles and measures necessary
to check them.
(5) Change In the General Price-Level: Several changes occur in the general value of money or the general
price-level. Rill in the value of money or rise in price-level is called Inflation and fall in price-level is called
Deflation. In order to put under control, changes in value of money, the economists heavily draw upon the study
of macro economics.
(6) Economic Growth: The problem of increasing the rate of economic development has assumed great
significance in under-developed countries. Macro economic analysis has made it possible to know the factors,
accounting for economic growth and policies to be pursued to achieve the same.
(7) Helpful In the Study of Micro Economics: Study of macro economics has great role in constructing the
theories and principles of micro economics. For example, it was on the basis of the study of the behaviour of
groups of consumers that the Law of Diminishing Marginal Utility could be propounded. Such a study led to the
conclusion that when the consumption of the quantity of a commodity is increased, its marginal utility begins to
diminish. In reality, no law of micro economics can be formulated without the study of relevant aggregates.
(8) Estimate of Material Welfare : Promotion of physical welfare of the people is the goal of every economy.
Whether material welfare has increased or not cannot be ascertained from the study of individual units. It can be
made sure by studying the aggregates, such as. total income, total employment, aggregate consumption etc.
Macro economics, therefore, helps in assessing material welfare.
(9) International Comparisons: Macro economics helps in making international comparisons. It can compare
rate of per capita income, investment-rate, consumption and saving levels of different economies.
Determination of exchange-rates of different countries is possible through macro economic analysis alone.
(10) Economic Planning: Present is an age of economic planning. Knowledge regarding mutual dependence of
different sectors, composition of national income, level of unemployment, nature of poverty etc. is essential for
formulating a comprehensive economic plan. Knowledge of these aggregates is possible, through the study of
macro economics.
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6.3 Uses or Importance of Macro Economics

Module A: Concepts of Economics and Demand Supply Analysis
(11) Inter-relationshlp among different Sectors: Nature of every economic system depends on the Inter-
relationship among different economic sectors and their mutual dependence. Knowledge regarding inter-
relationship and mutual dependence among public and private-sector?, agricultural and industrial sectors,
internal and Inter-national trade sectors can be possible only through their study at macro level.
(12) Helpful In understanding Macro-economic Paradoxes: Macro economic paradoxes refer to those
concepts which hold good for an individual but when they are applied to all the people their validity becomes
doubtful. For example, (i) if a farmer works hard and nature co- operates, he will have good crop and rise in his
income ; however, if all farmers work diligently and there is bumper crop throughout the country, the prices of
agricultural products will fall heavily causing fall in aggregate agricultural income. (ii) If an Industry increases
the prices of its products then all the firms in that industry will stand to gain. On the contrary, if prices of the
products of all industries rise in the same proportion, no one will gain thereby. Study of macro economics helps
in understanding these paradoxes. Prof. Boulding has rightly said in this respect, "In comparison to other
causes, study of the economy as a whole is very essential to solve these paradoxes."
In short, the most important problems of an economy, namely, unemployment, inflation, unbalanced budget,
poverty, economic growth, economic planning, role of government in the economy etc. are studied under macro
economics. In this context, Prof. Kurihara says, "There is much practical advantage in seeing through all the
complex inter-relationships of the economy as a whole and in concentrating on large aggregates which affect
the whole economy."
Main limitations of macro economics are as under:
(1) Dependence on Individual Units: Several conclusions of macro economics are based on the sum total of
individual units. In fact, it is not correct, because what is true for individuals may not necessarily be true for the
whole economy. For instance, an individual may save In terms of money but if
everybody starts saving, the aggregate demand will fall causing reduction in national income. It will result into
fall and not rise in aggregate saving. Prof. Samuelson has called it. "The fallacy of composition." According to
him, the tendency of excessive generalization on the part of macro economics is to apply individual experiences
to the economy as a whole, is not proper.
(2) Heterogeneous Units: Under macro economics,heterogeneous units are studied. These units are measured
in different ways. It is not possible to express these units in uniform numbers or homogeneous measure.
Prof.Boulding has Illustrated this point as follows :
6 apples + 7 apples - 13 apples (It is a meaningful aggregate)
6 apples + 7 oranges = 13 Fruits (It is also a meaningful aggregate)
6 apples + 7 houses = (It Is a meaningless aggregate)
The above illustration proves that it is not possible to aggregate, and express in a proper way. heterogeneous
units. Such units are measured in terms of money in economics. However, money value is not the true measure
of their value-in-use.
(3) The composition of Structure of the Aggregate Is more important than the Aggregate itself: Macro
economics studies aggregate but as a matter of fact. It is the composition of the structure of the aggregate which
influences an economy more than the aggregate itself. Supposing, price-level In 1993 and 1994 remains
constant but it does not imply that no change in prices took place in 1994. It is possible that prices of foodgrains
might have fallen in 1994 and that of industrial goods has risen correspondingly, keeping the general price-level
constant. Thus, for a proper study of an economy, knowledge of the composition of the structure of the
aggregate is as much essential as the aggregate itself.
(4) Different Effects of Aggregates: Another difficulty in the study of macro economics is that it does not
study the different effects of an aggregate on different sectors of an economy. Macro economic tendency has
not a uniform effect on all sectors of an economy. For example, rise in price-level benefits the traders and the
industrialists but the wage-earners are the losers.
3
6.4 Limitations of Macro Economics

(5) Limited Application: Another limitation of macro economics Is that most of the models relating to it have
only theoretical significance. They have very little use In practical life. Moreover, it is very difficult to measure
various aggregates of macro economics.
(6) lt Ignores the contribution of Individual Units: Macro economic analysis throws light only on the
functioning of the aggregates. However, in real life.the economic activities and decisions taken by individual
units on private-level have their effects on the economy as a whole. Such effects are not known by the study of
macro economics alone.
The present form of macro economics that we study is based on Keynes' famous book "The General Theory of
Employment, Interest and Money" published in 1936. Macro economics has therefore, almost the same features
and assumptions as are found in Keynes' General Theory. Salient features of macro-economics are as under:
(l)The Short-run Nature of Macro Economics : Macro economics is a short-run study. Short-run refers to that
time period in which production cannot be increased by installing new plants or new machinery or by changing
the technique of production. It lays emphasis on those problems which are
keenly fell under Ihe existing circumstances. Short-run nature of macro economics can be expressed as below :
(i) In the short period, the quantity and quality of labour, the amount of capital, the existing technique, the
extent of competition, the degree of monopoly, tastes of the people, broad social structure, etc., remain constant
and there is no significant change in them.
(ii) Although employment can be increased by increasing both consumption and investment, yet in macro
economics in order to increase employment more stress has been laid on increase in investment as against
increase in consumption. It is so because in the short-run consumption habits of the people remain constant
while changes can be effected in investment,
(iii) National output or aggregate supply (AS) is assumed to be constant in the short-run, and
(iv) Labour alone is the variable factor in the short-run and as such output can be increased by increasing the
level of employment. In other words, output and employment change in the same proportion.
(2) Study of the Whole Economy: Macro economic analysis is a study of the economy as a whole. It deals
mainly with national income or national output, aggregate consumption, aggregate investment, effective
demand, price level, full employment, less than full employment etc. It does not study the income of an
individual. or the price of a commodity, wage of a labourer, production of a firm. etc. Study of macro
economics proves that an economic law or theory that applies to an individual may not necessarily be applicable
to the whole economy. For instance, to save is a private virtue but it is a social vice. Again, reduction in money-
wage, in a particular industry, may result in more employment; but if wage-cut is applied to the entire economy,
it may cause wide-spread unemployment. Study of macro economics is based on semi general equilibrium,
while study of micro economics is based on the concept of partial equilibrium.
(3) Macro Economics — A Syctematised and Comprehensive Body of Thought: Macro economics is a
comprehensive study of all conditions. It studies all conditions of inflation and deflation; boom and depression:
full employment and under employment. Allegation by Hicks and Schumpeter, that macro economics is an
economic analysis of depression, is Improper. If has been referred to as an economics of depression alone,
because an extensive study of depression and unemployment is made in General Theory. The reason being that
General Theory was written after the Great Depression of 1930. But it does not mean that it does not deal with
other economic problems like inflation, full employment, over-employment etc. According to macro economics,
deficiency of effective demand causes deflation and its excess causes inflation. Macro economics suggests
remedies for both these problems. In fact, the main problem of macro economics is that of effective demand. Its
deficiency causes unemployment and depression and its excess accounts for increase in employment and price-
levels.
(4) Macro Economics-Reformed Capitalism or Nco-liberal ism : Macro economics aims at reforming and
not destroying capitalism. It asserts that capitalism as existed prior to world war 1 has no place in the changed
conditions of the present-day world. Different laws of macro economics are based on different features of
capitalism, like, private property, freedom of choice, profit motive and price mechanism. However these laws
4
6.5 Salient Features of Macro Economics

do not agree with the belief of capitalism that government should not interfere with the working of economic
system nor that there is automatic adjustment In the economy. Macro economics has supported government
interference with the working of economic system. It has rightly been remarked by Harris, "Macro economics,in
reality supports capitalism. Its objective is to save and not destroy capitalism." Macro economics suggests
social control of investment, public works
programmes and adoplion of cheap money policy to mobilise resources. Government interference in economic
sphere has been recommended for the successful functioning of private enterprise.
(5) Macro Economlcs-A Monetary Economics: Classical economists laid more stress on real, rather than
monetary factors in their economic analysis, because to them the main function of money was medium of
exchange. It was a mere veil having no effect of its own on the determination of economic activities. But macro
economics has given due importance to monetary factors also. According to macro economics, changes in
demand for and supply of money have significant effect on the determination of income and employment.
Rate of interest is determined by the interaction of the forces of demand for and supply of money. Increased
supply of money causes fall in the rate of Interest which, in its turn, encourages more investment, more
production and more employment. Macro economics has given much importance to the 'store of value' function
of money. People hold most of their savings in cash balances form (liquid), because by doing so their
uncertainty ends. Money in liquid form provides security against uncertain future. Prof. Dudley DM lard has
aptly remarked.'Ownereo/money haue a type of security which owners of other kinds of wealth do not enjoy.1
' In
the words of Keynes, " Holding of cash balances subsides our anxiety." Money, as a matter of fact, is a great
source of inspiration for all economic activities. It is therefore, no exaggeration to say that macro economics is a
monetary economic analysis.
(6) Macro Economics-Mainly Institutional: Another feature of macro economics is that it is institutional in
nature. We cannot understand its real nature unless we examine such economic factors as rate of interest,
saving, investment, supply of money and psychological and institutional factors influencing propensity to
consume. That is the reason why macro economics is more real and practical. It serves as a guide to the
politicians and economists all over the world. The entire structure of macro economics will undergo a change if
there is change in its institutional factors. To comprehend micro economics we must keep in view its
psychological and Institutional factors. Without these factors macro economics is devoid of its practical value.
(7) Importance of State Intervention: Macro economics has laid great stress on the role of state intervention
in economic sphere. In order to make up the shortfall in private investment, public investment is regarded most
desirable. State Is like a balancing factor. State intervention is not meant to abolish private enterprise but it is to
help it. In the words of Keynes, " While increase in government functions may appear to be a dangerous
interference with individualism of the kind of 19th century economists; I, on the contrary, support It for the
success of private Incentive." State plays a very significant role in raising propensity to consume by its policy of
equitable distribution of wealth. By lowering the rate of interest, state provides necessary incentive to the
entrepreneurs to increase investment. Public works programmes and policy of deficit financing are strongly
advocated In macro economics to remove unemployment. In the words of Benjamin Higgins "The analysis
o/the.Genera/ Theory conferred a new importance and respectability on public investment policy. It has been
elevated from the rank of the last line of defence to major offensive."
(8) The Crucial Role of Investment: In macro economics, a very important role is assigned to investment.
Investment means addition to the stock of goods and creation of new capital assets. In the words of Dillard,"
Macro economics reduced to its simplest, states that employment depends upon the amount of investment.'
According to macro economics, change in employment depends on change in
effective demand. Effective demand depends on consumption demand and investment demand. In the short-run.
consumption does not increase in the same proportion as the increase in income. Thus, a gap is created between
income and consumption . It results into deficiency of effective demand and hence unemployment. To fill this
gap and to raise the level of employment, it becomes necessary to increase investment. Dillard has rightly said.
"Employment fluctuates primarily because investment fluctuates. Unemployment results primarily from an
inadequacy of investment "Both private and public investments have therefore, been considered necessary for
increasing the level of employment, in macro economics.
(9) Comparative Static Analysis: There are three concepts of economic analysis, viz, (i) Static (ii)
Comparative Static and (Hi) Dynamic. Under static economic analysis one studies the conditions of equilibrium
5

arising out of economic variables relating to a given period of time. Under comparative static analysis, new
equilibrium position, consequent upon change in one economic variable, is compared with old equilibrium
position. Economists are not unanimous on the kind of economic analysis that macro economics be related to.
Some economists like. Schumpeter and Harrod relate it to static analysis, because it assumes a definite relation
between employment and output. Prof. Hansen regards it as comparative static analysis because, it compares the
equilibrium of different time period. Prof. Hicks however regards it as dynamic analysis. According to him,
macro economics analysis is dynamic analysis because of the excessive use of "expectations" in it. These
expectations have their effect on investment, cash balances and multiplier, etc. In short, it can be said that macro
economics has an element of both static and dynamic analysis. Macro static and macro comparative static deal
often with the determination of the level of employment. On the other hand, macro dynamic deals with
economic growth.
(9) Comparative Static Analysis: There are three concepts of economic analysis, viz, (i) Static (ii)
Comparative Static and (Hi) Dynamic. Under static economic analysis one studies the conditions of equilibrium
arising out of economic variables relating to a given period of time. Under comparative static analysis, new
equilibrium position, consequent upon change in one economic variable, is compared with old equilibrium
position. Economists are not unanimous on the kind of economic analysis that macro economics be related to.
Some economists like. Schumpeter and Harrod relate it to static analysis, because it assumes a definite relation
between employment and output. Prof. Hansen regards it as comparative static analysis because, it compares the
equilibrium of different time period. Prof. Hicks however regards it as dynamic analysis. According to him,
macro economics analysis is dynamic analysis because of the excessive use of "expectations" in it. These
expectations have their effect on investment, cash balances and multiplier, etc. In short, it can be said that macro
economics has an element of both static and dynamic analysis. Macro static and macro comparative static deal
often with the determination of the level of employment. On the other hand, macro dynamic deals with
economic growth.
(10) A Theory of Shifting Equilibrium : According lo macro economics position of equilibrium refers to the
position of equality between demand and supply. Such an equilibrium position is possible under any of the three
conditions, namely, full employment. under employment equilibrium and over full employment. It is therefore,
a theory of shifting equilibrium. Macro economics lays great stress on the fact that underemployment
equilibrium is more realistic than full employment equilibrium. In the words of Haberler, "Under employment
equilibrium is a notable contribution of Keynes' General Theory".
This theory reveals two things : (i) Reduction in money wage cannot bring about position of full employment,
and (ii)Under employment equilibrium arises due to short fall in private investment. To make up this shortfall
public investment should be encouraged.
(11) The Role of Expectations In the Economies: One of the main features of macro economics is that many
of its basic variables, such as investment, multiplier, liquidity preference are influenced by expectations.
Expectation means hope of profit in the future. Investment is governed by marginal efficiency of capital (MEC)
and marginal efficiency of capital is governed by expected profitability. If the entrepreneur is optimistiche will
make investment, otherwise not. Similarly, the concept of liquidity preference is also dependent on future
estimations. How much cash balances will be held by the people depends on the future rate of interest. Hicks
has rightly said, "Use of the methods of expectations is perhaps the most revolutionary contribution of General
Theory." These expectations have their influence both on investment and employment.
(12) Macro Economics-Based on Firm Empirical Foundation: Macro economics is based on sound practical
experiences. It is realistic. Many economists have proved its realism. Its laws are not of theoretical importance
only but they also serve as guidelines to the present day politicians. 'New Deal’ programme of America was
chalked out under the influence of macro economics. It is aptly remarked by Prof. Kl c in," Keynesian System is
firmly rooted in facts."
(13) Macro Economics — General Theory: Macro economics is called a General Theory because of three
reasons : (I) It is a general theory because it studies all levels of employment. It discusses unemployment, full
employment, underemployment and over full employment, (ii) It discusses inflation and deflation also
alongwith employment and unemployment. All these variables are assumed to be based on effective demand.
Deficiency of effective demand is the cause of unemployment and deflation and excess of effective demand
6

results in more employment and inflationary situation, (iii) It studies the changes in total employment, total
output and other aggregative variables.
(14) Role of Consumption: Consumption expenditure and Psychological law of consumption are of great
importance in macro economics. In determining the level of employment the role of consumption is no less
important than that of production. It is consumption that gives rise to demand and hence to production. More
production implies more employment. Macro economics has proved with the help of Psychological law of
consumption, that consumption does not increase in the same proportion as the production does. It is the main
cause of fall in effective demand and hence unemployment. Harris has aptly said, "Consumption function is one
of the comer-stones of the Keynesian structure.' Many economic problems like over-production, decline in
marginal efficiency of capital, secular stagnation and trade cycles, etc., can be solved with its help.
(15) Role of National Income: Macro economics has given great importance to the study of national income.
According to Keynes, without the help of national income, problems of national output and employment cannot
be solved. Its study makes available to us necessary statistical data pertaining to consumption, saving
employment, investment etc. It is again macro economics that made the development
Three conditions of the mixed economy that are most important for macroeconomics, including full
employment, stability, and economic growth, that are generally desired by society and pursued by governments
through economic policies. Macroeconomic goals are three of the five economic goals of a mixed economy that
are most important to the study of macroeconomics. They are full employment, stability, and economic growth.
1. Full Employment
Full employment is achieved when all available resources (labor, capital, land, and entrepreneurship) are used to
produce goods and services. This goal is commonly indicated by the employment of labor resources (measured
by the unemployment rate). However, all resources in the economy--labor, capital, land, and entrepreneurship--
are important to this goal. The economy benefits from full employment because resources produce the goods
that satisfy the wants and needs that lessens the scarcity problem. If the resources are not employed, then they
are not producing and satisfaction is not achieved.
2. Stability
Stability is achieved by avoiding or limiting fluctuations in production, employment, and prices. Stability seeks
to avoid the recessionary declines and inflationary expansions of business cycles. This goal is indicated by
month-to-month and year-to-year changes in various economic measures, such as the inflation rate, the
unemployment rate, and the growth rate of production. If these remain unchanged, then stability is at hand.
Maintaining stability is beneficial because it means uncertainty and disruptions in the economy are avoided. It
means consumers and businesses can safely pursue long-term consumption and production plans. Policies
makers are usually most concerned with price stability and the inflation rate.
3. Economic Growth
Economic growth is achieved by increasing the economy's ability to produce goods and services. This goal is
best indicated by measuring the growth rate of production. If the economy produces more goods this year than
last, then it is growing. Economic growth is also indicated by increases in the quantities of the resources--labor,
capital, land, and entrepreneurship--used to produce goods. With economic growth, society gets more goods
that can be used to satisfy more wants and needs--people are better off; living standards rise; and scarcity is less
of a problem.
4. Tradeoffs
The three macroeconomic goals of full employment, stability, and economic growth are widely considered to be
beneficial and worth pursuing. Each goal, achieved by itself, improves the overall well-being of society. Greater
employment is typically better than less. Stable prices are better than inflation. Economic growth is better than
stagnation.
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6.6 MACROECONOMIC GOALS

5. Policies and Politics
The pursuit of these three macroeconomic goals is inherently an act of normative economics. In fact, the "norm"
part of term normative economics is synonymous with the word "goal." Normative economics is essential to the
pursuit of economic goals.
In a mixed economy, the pursuit of these goals is largely directed by governments. This, of course, brings into
play the wonderful world of politics and never-ending debates over which of these three macroeconomic goals
is most worth pursuing with economic policies.
As the discussion turns to politics and policies, two viewpoints tend to emerge--liberal and conservative.
Generalities are, of course, fraught with exceptions. However, with that caution in mind, note that each of the
two political views have historically placed greater emphasis on the attainment of some goals over others.
Liberals have tended to seek full employment over stability and economic growth. Conservatives, in contrast,
have sought economic growth and stability, especially price stability, more so than full employment.
Macroeconomic markets are commonly aggregated into theoretical constructs that combine the activity in
hundreds of thousands of individual microeconomic markets. These three aggregated macroeconomic markets
are characterized by the basic types of commodities exchanged.
1. Product Markets: The product markets, also termed goods or output markets, exchange the production of
final goods and services, what is formally termed gross domestic product. The buyers of this production are the
four macroeconomic sectors--household, business, government, and foreign. The seller of this production is
primarily the business sector. A substantial part of macroeconomics is devoted to explaining how and why gross
domestic product exchanged through the product markets rises or falls. When Duncan Thurly purchases a
Deluxe Club Sandwich from Manny Mustard's House of Sandwich, he is operating through the product market.
2. Financial Markets: The commodity exchanged through financial markets is legal claims. Legal claims, or
financial instruments, represent ownership of physical assets (capital and other goods). Because the exchange of
legal claims involves the counter flow of income, those seeking to save income buy legal claims and those
wanting to borrow income sell legal claims. When Winston Smythe Kennsington III buys a few hundred shares
of OmniConglomerate, Inc. corporate stock, then he is operating in the financial markets.
3. Resource Markets: The services of the four factors of production--labor, capital, land, and
entrepreneurship--are traded through resource markets. Resource markets, also termed factor markets, are used
by the business sector to acquire the factor services needed for production. Payment for these factor services
then generate income received by the household sector, which owns the resources. When Pollyanna
Pumpernickel takes a job working at the Wacky Willy factory assembling Wacky Willy Stuffed Amigos, then
she is participating in the resource markets. Note only factor services are exchanged through factor markets, not
the actual factors.
The four macroeconomic sectors take part in each of the three sets of markets in various ways. Consider which
sectors are the primary buyers and sellers for each market.
1. Household Sector: The household sector is the primary participant on the buying side of the product
markets. This sector regularly purchases almost two-thirds of all gross domestic product exchanged through the
product markets. This sector, in that it owns all resources, is also on the selling side of the resource markets. In
fact, the income that it uses to purchase gross domestic product comes from selling factor services through the
resource markets. Lastly, the household sector is on the buying side of the financial markets. When it buys legal
claims, it is lending (or saving) income.
2. Business Sector: The business sector is THE primary participant on the selling side of the product markets.
This is the sector responsible for production. However, it also purchases capital goods through the product
markets, meaning it operates on both the selling side and the buying side. This sector is also on the buying side
of the resource markets. It acquires the factor services used for production from the household sector through
8
6.7 macroeconomic markets
6.8 macroeconomic sectors

the resource markets. Lastly, the business sector is largely on the selling side of the financial markets. When it
sells legal claims, it is borrowing income that is more often than not used to purchase capital goods.
3. Government Sector: The government sector participants on the buying side of the product markets along
with the household and business sector. The government acquires a portion of gross domestic product in the
course of pursuing its designated functions. This sector also surfaces on the selling side of the financial markets.
If often sells legal claims to raise funds needed to pay for the purchase of gross domestic product.
4. Foreign Sector: The foreign sector participants in the product markets, on both the buying side and the
selling side. When goods are exported from the domestic economy, the foreign sector is on the buying side of
the product markets. When goods are imported into the domestic economy, the foreign sector is on the selling
side of the product markets.
The product, financial, and resource markets represent conduits of exchange activity among the household,
business, government, and foreign sectors. In other words, commodities flow through these markets from sector
to sector in a continuous, circular fashion. A standard circular flow model is presented in the exhibit to the right.
The Circular Flow
1. Household Income: The income received by the household sector at the far left is generated by selling factor
services to the business sector. This income is then used to purchase goods produced by the business sector.
2. Business Revenue: The revenue received by the business sector at the far right is generated by selling
production to the other sectors, especially the household sector. This revenue is then used to buy the factor
services supplied by the household sector.
3. Government Taxes, Borrowing, and Spending: The tax revenue collected by the government sector in the
center of the exhibit from the household sector is used to purchase output from the business sector through the
product markets. The government sector also pays for a portion of these purchases with household sector saving
that is borrowed through the financial markets. The resulting business sector revenue is then used to pay for
factor services which becomes income that the household sector uses for taxes and saving.
4. Foreign Exports and Imports: The imports sold by the foreign sector at the very top to the domestic
economy generates revenue that is often used to purchase exports from the domestic economy.
Around and around and around it goes. Activity flows from sector to sector through each of the three markets.
9
6.9 A Circular Flow of Activity
6.10 MACROECONOMIC PROBLEMS

Macroeconomic problems arise when the macroeconomy does not satisfactorily achieve the goals of full
employment, stability, and economic growth. Unemployment results when the goal of full employment is not
achieved. Inflation exists when the economy falls short of the stability goal. These problems are caused by too
little or too much demand for gross production. Unemployment results from too little demand and inflation
emerges with too much demand. Stagnant growth means the economy is not adequately attaining the economic
growth goal. Each of these situations is problematic because society is less well off than it would be by reaching
the goals.
1. Unemployment
Unemployment arises when factors of production that are willing and able to produce goods and services are
not actively engaged in production. Unemployment means the economy is not attaining the macroeconomic
goal of full employment.
While attention is usually focused on the unemployment of labor, such as the time Pollyanna Pumpernickel was
laid off from her job at the OmniMotors Car Company, any of the four factors of production can suffer
unemployment. For example, The Wacky Willy Company might be operating one of its Stuffed Amigos
factories at half capacity or Herb Haberstone might leave a section of his farmland uncultivated.
Unemployment is a problem because:
a. Less output is produced and thus the economy is less able to address the scarcity problem.
b. The owners of unemployed resources receive less income and thus have lower living standards.
2. Inflation
Inflation arises when the average price level in the economy consistently and persistently increases. In other
words, prices generally rise from month to month and year to year. With inflation the economy is not attaining
the stability goal.
Inflation is an average increase in prices, with some prices rising more than the average, some rising less, and
some even declining. As such, not every member of society is likely to experience exactly the same inflation.
Inflation is a problem because:
a. The purchasing power of financial assets such as money declines, which reduces financial wealth and lowers
living standards.
b. Greater uncertainty surrounds long-run planning, especially the purchase of durable goods and capital goods.
c. Income and wealth can be haphazardly redistributed among sectors of the economy and among resource
owners.
3. The Business Cycle
Unemployment and inflation tend to vary with business-cycle instability. At some times, unemployment is less
of a problem and inflation is more. At other times, unemployment is more of a problem and inflation is less.
Consider how these two problems connect to the two primary phases of the business cycle.
a. Contraction: The contraction phase of a business cycle is characterized by a general decline in economic
activity. Aggregate demand is less, meaning less output is produced, and thus fewer resources are employed.
For this reason, unemployment tends to be a key problem. However, because markets are more likely to have
surpluses than shortages, inflation tends to be less of a problem.
b. Expansion: The expansion phase of a business cycle is characterized by a general rise in economic activity.
Aggregate demand is higher, production is greater, and more resources are employed. Demand for production
often outpaces the ability to supply the production. Under these circumstances, because markets are more likely
to have shortages than surpluses, inflation tends to be the primary problem. However, with robust production
and jobs aplenty, unemployment tends to be less of a problem.
4. Stagnant Growth
The third problem of stagnant growth arises because the supply of aggregate production is not increasing at a
desired pace or is even declining. An increase in the total production of goods and services is generally needed
to keep pace with an increase in the population of society and expectations of a rising living standard. Stagnant
10

growth exists if total production does not keep pace. This means the macroeconomic goal of economic growth
is not attained.
Reasons for stagnant growth can be identified with a closer look at the quantity and quality of the resources
used for production.
a. Quantity: The available quantities of the four factors of production--labor, capital, land, and
entrepreneurship--can restrict the growth of production.
The quantity of labor is based on both the overall population and the portion of the population willing and able
to work. Should either decline, then growth is not likely to keep pace with expectations. If, for example, Edgar
Millbottom decides to quit his job and spend his time doing nothing but vegetating on his parents living room
sofa, then the total quantity of labor declines.
The quantity of capital depends on the amount of investment expenditures relative to the depreciation of the
existing capital stock. If investment expenditures should decline or depreciation increase, then the economy is
less likely to grow. If, for example, restrictive government regulations and high taxes discourage The Wacky
Willy Company and similar manufacturing companies from building new factories, then the total quantity of
capital declines.
b. Quality: The quality of the four resources can also lead to stagnant growth. The two most noted resource
quality influences are technology and education. The lack of technological progress, which could result from
allocating fewer resources to scientific research can limit increases in the quantity of resources. Along a similar
line of reasoning, allocating fewer resources to education can also limit resource quality.
Every country witnesses boom and depression periodically. Depression is characterised by falling production,
falling prices and rise in unemployment. On the other hand, boom is characterised by rising production, rising
prices and high employment percentage. These changes of boom and depression are cyclical in form. Hence,
these are called Trade or Business Cycles. Rhythmic fluctuations taking place in an economy, at intervals in the
form of boom and depression are called Trade or Business Cycles.
Definition
1. According to W.C. Mitchell, an eminent American economist, "Business cycles are a type of fluctuations
found in the aggregate economic activity of nations that organise their work mainly in business enterprises. A
cycle consists of expansion occuring at about the same time in many economic activities followed by similar
general recession, contractions and revivals which merge with the expansion phase of the next cycle, this
sequence of changes is recurrent but not periodic".
It follows from the above definition that trade cycles (1) Take place in Capitalist or Mixed economies,
(2) They relate to all economic activities, (3) Trade or Business Cycles have four phases: Expansion, Recession,
Contraction and Revival, (4) Their period is not fixed but occur again and again.
In the words of Lord Keynes, "A trade cycle is composed of periods of good trade characterised by rising
prices and low unemployment percentage alternating with periods of bad trade characterised by falling prices
and high unemployment penzentage".
According to Anatol Murad, "Business cycles are alternations of prosperity and depression". — Hanson
defines, "TradeCycleis peculiarly a manifestation of industrial segment of the economy from which prosperity
or depression is redistributed to other groups in the highly inter-related modern system."
From the above definitions it is clear that a trade cycle is characterised by a period of good trade, rising prices
and low level of unemployment, alternating with a period a bad trade which Is characterised by falling prices
and high level of unemployment. It is a very complicated phenomenon. Economists have not been able to arrive
at a unanimously agreed conclusion regarding the nature and the period of a trade cycle.
11
6.10 Trade Cycle
6.10 Types of Trade Cycles

Prof. Schumpeter has divided trade cycles into three types :
(1) Major Cycles: These are of the duration of 8 to 12 years. They were first explained by French economist
Juglar. Hence Ihey are called Juglar cycles.
(2) Minor Cycles: Duration of these cycles is from 2 to 5 years. They were first mentioned by an English
economists Kitchen. Hence, they are called Kitchen Cycles. A major cycle comprises of many minor cycles. For
instance, the period from 1921 to 1932 is characterised by major cycle. However, it comprised many minor
cycles i.e.. 1921-24. 1924-27. 1927-32.
(3) Very Long Cycles: These are prolonged cycles with their duration ranging from 50 to 60 years. There were
first referred to by Russian economist Kondratleff. Hence they are called Kondratleff Cycles. A very long cycle
may contain in itself many major and minor cycles.
According to Prof. Schumpeter a trade cycle can have four phases :
(1) Expansion or Boom
(2) Recession
(3) Depression or Trough or Contraction
(4) Recovery
The following figure illustrates all the four phases or stages of trade cycles:
(1) Expansion or Boom
This phase of the trade cycle represents the best stage of prosperity. The objective of the national economic
policy of each country is to attain this stage. In this phase hectic economic activities go on and factors of
production are put to optimum use. Expansion or prosperity is a state of affairs in which real income consumed
and real income produced and the level of employment are high or rising and there are no idle resources. The
main characteristics of this phase are as under :
(1) Income or production is the maximum. Level of income is sufficiently high. Because of the interaction of
multiplier and accelerator, increase in income is many times more than that of increase in investment.
(2) The economy reaches full employment by removing unemployment. Beyond the stage of full employment,
the economy experiences over full employment and hence rise in prices and wages.
(3) Prices rise very high.
(4) Wage rate is very high. All those persons who are willing to work, get work at reasonable wages.
(5) Traders and industrialists earn huge profits.
(6) There is expansion in bank credit.
12
6.10 Phases of Business Cycles

(7) All kinds of investment increase. Entrepreneurs expand their business by borrowing from the banks. In the
words of Haberler, "Expansion or prosperity is a state of affairs in which real income consumed and real income
produced and the level of employment are high or rising and there are no idle resources".
(8) There is increase in consumption expenditure. Consequently, demand also increases.
(9) Rate of interest rises. However, rise in rate of interest is less than the rise in the rate of profit. As such there
is lot of inducement to invest on the part of the entrepreneurs.
(10) All entrepreneurs and traders become oplimists. Share prices rise and there is all round increase in
investment.
(2) Recession
Under the phase of prosperity, the entrepreneurs make investment in certain ventures which do not prove to be
profitable. Their optimism gives way to pessimism. Investment shows signs of decline. Many enterprises are
closed down. Unemployment spreads and income of the people falls. As a matter of fact, beyond the stage of
full employment, any increase in investment is followed by increase in interest, wages and other costs.
Consequently, prices rise sharply causing fall in demand. Fall in demand obliges the firms to sell their stocks at
reduced prices. This paves the way for Recession. In this phase there is decline in economic activities. The main
features of this phase are as under-
(1) There is fall in income and output.
(2) Workers are rendered unemployed.
(3) Prices begin to fall.
(4) Wages Fall.
(5) Profits fall. There is no new borrowing despite fall in the rate of interest. (6) There is contraction of bank
credit.
(7) Fall in investment sets in motion the reverse action of the multiplier. Consequently, income falls many times
more than the decline in Investment.
(8) Demand of the consumers for various goods fall.
(9) There is sharp decline in the stocks of goods.
(10) There is a feeling of doubt and fear among the people.
(3) Depression or Contraction
Once the process of recession starts it becomes clmost difficult to stop the rot. It goes on gathering momentum
and ends in hopeless depression. Consequently, economic activities are faced with depression or contraction.
Level of output and employment is extremely low. There is heavy fall in prices and wages. Prices of goods fall
much more than wages and interest resulting into heavy losses to the entrepreneurs and traders. Workers are hit
adversely because of widespread unemployment.
Production and distribution systems of the economy go out of gear. Heavy fall in profits serves as a disincentive
to any new investment. Although rate of interest falls yet no new investment takes place as marginal efficiency
of capital falls more than proportionate fall in rate of interest. Under depression, prices of raw material fall more
than the prices of finished products. Economic condition of farmers and producers of raw material grows worse
than that of the traders and producers of finished goods. Because of the reverse action of the multiplier and the
accelerator, there is heavy fall in income. Share prices fall rapidly. Many industries are ruined. It adversely
affects the entire economy. Thus, under depression all economic factors like income, output, employment,
prices, profit, interest, wages, demand, etc have a tendency to contract.
Salient features of this phase are as follows:
(1) Level of output and income is low.
(2) Unemployment increases.
(3) Wages, interest and other costs decline.
(4) Price-level falls.
(5) Volume of profit falls sharply. Hence, despite fall in the rate of interest, inducement to invest is low.
(6) Cash reserves with the banks pile up and demand for credit falls.
(7) Old and worn-out machines are not replaced. Hence, demand for capital good falls.
(8) Demand for consumer goods falls.
13

(9) There is an all-round decline in investment causing reverse action of multiplier and accelerator.
(10) People grow pessimist. It affects economy adversely.
(4) Recovery
It is worth noting that Depression phase cannot last for ever. During the phase of depression the entrepreneurs
do not even replace machines and other capital goods. Production falls considerably. Stocks of goods are at
their lowest. Even during the phase of depression a situation does arise wherein shortage of goods is
experienced. Need for replacement of machines becomes so imperative that the entrepreneurs are obliged to buy
new machines to replace old and worn out ones. It results into more demand for capital goods. Investment in
capital goods industries is increased. As a result of it, interaction of multiplier and accelerator comes into play
and there is Increase in income. Demand for goods rises. There is increase in output and employment. Thus, the
economy gradually moves from depression to recovery. The wave of recovery once initiated begins to feed up
itself. The main features of recovery are as follows:
(1) Replacement Investment results into increase in income and output.
(2) Employment increases.
(3) Demand for consumption and production goods rises.
(4) Prices begin to look up.
(5) There are more profits.
(6) Costs increase relatively less.
(7) Investment increases.
(8) Demand for bank loans and advances increases.
(9) Pessimism gives place to optimism.
The policy goals of macroeconomic policy vary from country to country and according to the political priorities
of different governments Trade cycles affect the economic life adversely. These cycles generate the situation of
instability in terms of inflation, deflation and unemployment. It is essential to control their occurrence, and it
can be done pursuing the following policies:
(1) Monetary Policy
Monetary Policy refers to the regulation and control of (i) Row of credit (ii) supply of money and (iii) rate of
interest in the economy with a view to restore economic stability. In the words of D.C. Aston, "Monetary policy
involves the influence on the level and composition of aggregate demand by the manipulation of interest rates
and the availability of credit."
Monetary instruments are used to stimulate the flow of credit as well as to suppress it. During periods of
inflation, flow of credit needs to be restricted. Accordingly dear monetary policy is adopted. This aims at
increasing the rate of interest, selling the government securities in the open market, raising the liquidity ratio as
well as cash reserve ratio of the commercial banks. Requirement of 'margin' is also raised. In general banks are
advised to restrict the availablity of credit.
During period of deflation, cheap monetary policy is adopted. Rate of interest is reduced, government securities
are purchased in the open market, cash-reserve ratio as well as liquildity ratio of the commercial banks are
reduced. Also, the requirement of margin is slashed. As a consequence, flow of credit picks up which is
expected to stimulate business activity and the level of employment.
However, it should be noted that monetary policy is alone seldom succeeds as an effective instrument to control
trade cycles. It needs to be carefully supplemented with Fiscal Policy, discussed as under.
(2) Fiscal Policy
14
6.10 Macroeconomic Policy

Economic activity of the government has greatly increased in the recent past. The government can significantly
influence the occurrence of trade cycles by way of its fiscal policy that relates to its revenue and expenditure.
According to Prof. G.K. Shaw, "Fiscal Policy is the policy concerning the revenue, expenditure and debt of
the government for achieving definite objectives."
Fiscal instruments that control the occurrence of trade cycles are generally classified as: (i) Built-in-Stabilizers,
and (2) Discretionary Measures.
(A) Built-in-Stabilizers: These refer to those fiscal parameters that start operating in the system automatically.
These are therefore, also called Automatic Stabilizers. These built-in-stabilizers automatically change the flow
of income or money between individuals and corporations on the one hand and the government on the other.
And the change is such as to be appropriately counter-cyclical in its direction.
Built-in-stabilizers work, as Automatic Shock Absorbers reducing the operation and intensity of the cycle.
Following are some of the notable examples of these stabilizers:
(i) Progressive Taxation: It is a system of taxation in which rate of taxation increases with the level of income-.
In the state of prosperity as the level of income and profits rise, progressive taxation ensures more income to the
state in terms of tax revenue. As a consequence, purchasing power of the masses reduces that acts as a check on
the inflationary tendencies. Likewise, during the depression, progressive taxation reduces the tax revenue of the
state raises the availability of purchasing power with the masses that stimulates demand and business activity.
(ii) Unemployment Insurance: During period of prosperity, unemployment fund tends to increase. This is
because, during this period, payment in terms of unemployment relief-tends to reduce. On the other hand,
during depression, unemployment fund tends to deplete because of increased payments in terms of
unemployment relief. Expansion and contraction of the unemployment acts as a built-in check during period of
inflation and deflation, respectively. Expansion of the fund implies more purchasing power in the offers of the
government and less of it in the market which is what is needed during inflation. Likewise the contraction of the
fund implies more purchasing power in the market that stimulates the level of business activity.
Thus, it is the automatic changes in the flow of purchasing power between the government and the people that
act as built-in-stabilizers in the system during the periods of inflation and deflation.
(B) Discretionary Measures
These relate to policies of the government specifically designed to control cyclical changes in the system. These
include (1) Taxation Policy (2) Public Expenditure, and (3) Public Debt. These measures are of three types: (i)
Changing the public expenditure while tax-structure remains constant, (ii) Changing the tax structure, while
public expenditure remains constant, (iii) Changing both the tax structure as well as public expenditure
simultaneously. First category of measures are generally adopted during periods of depression. Second category
is considered most appropriate during depression. The thyd category becomes appropriate when cyclical
changes tend to assume chronic proportions in the system.
(C) Direct Controls
Direct controls relating to trade cycles include the following:
(1) Price Controls: That aim at fixation of prices of essential commodities in the market. Price controls also
include the support price policy of the government. Support price refers to the minimum price offered to the
farmers by the state for their produce.
(2) Quantity Controls: That relates to (a) the distribution of goods through Fair Price Shops, called Rationing,
and (b) Licensing policy of the government fixing production limits for certain strategic producing units in the
country.
(3) Wage Controls: That aim at the regulation of wages during periods of inflation and deflation.
15

Economics 6

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