CU M Com-MEBE-MOD-1-National Income Accounting-Lecture-1

SM/CU/MCOM/FIRST YEAR/MEBE/MOD-I/2017-18 MOOCS: subirmaitra.wixsite.com/moocs 1
Lecture-1
Macroeconomics is the study of the behaviour of the whole economy. It is concerned with
the determination of the broad aggregates in the economy, in particular the national output,
unemployment, inflation and the balance-of-payments position. The main body of
macroeconomic theory applies to a developed, capitalist economy.
The issues that macroeconomists address include the following:
What determines a nation's long-run economic growth? : Why do some nations’
economies grow quickly, providing their citizens with rapidly improving living standards, while
other nations' economies are relatively stagnant? From a macroeconomic perspective, the
difference between rich nations and developing nations may be summarized by saying that rich
nations have at some point in their history experienced extended periods of rapid economic
growth but that the poorer nations either have never experienced sustained growth or have had
periods of growth offset by periods of economic decline.
Figure 1 summarizes the growth in output of the U.S. economy since 1869. The record is an
impressive one: Over the past century and a third, the annual output of U.S. goods and services
has increased by more than 75 times. The performance of the U.S. economy is not unique,
however; other industrial nations have had similar, and in some cases higher, rates of growth over
the same period of time. This massive increase in the output of industrial economies is one of the
central facts of modern history.
In part, the long-term growth of the U.S. economy is the result of a rising population which
has meant a steady increase in the number of available workers. But at the same time the growth
of average labour productivity also increased remarkably, which further promoted the long-term
growth of the economy. The amount of output produced per unit of labour input—for example,
per worker or per hour of work—is called average labour productivity. In 1998, the average US
worker produced more than four times as much output as the average worker at the beginning of
the twentieth century, despite working fewer hours over the course of the year.

What causes a nation's economic activity to fluctuate? Why do economies sometimes
experience sharp short-run fluctuations, lurching between periods of prosperity and periods of
recession?
Fig: 1 Growth and Fluctuations in Real Output in US economy, 1869--1998
If we look at the history of U.S. output in Fig. 1, we shall notice that the growth of output
isn't always smooth but has hills and valleys. Most striking is the period between 1929 and 1945,
which spans the Great Depression and World War II. During the 1929-1933 economic collapse
that marked the first major phase of the Great Depression, the output of the U.S. economy fell by
nearly 30%. Over the period 1939-1944, as the United States entered World War II and expanded
production of armaments, output nearly doubled. No fluctuations in U.S. output since 1945 have
been as severe as those of the 1929-1945 period. However, during the postwar era there have
been periods of unusually rapid economic growth, such as during the 1960s, and times during
which output actually declined from one year to the next, as in 1973-1975, 1981-1982, and 1990-
1991.
Macroeconomists use the term business cycle to describe short-run, but sometimes sharp,
contractions and expansions in economic activity. The downward phase of a business cycle,
during which national output may be falling or perhaps growing only very slowly, is called a
recession. Even when they are relatively mild, recessions mean hard economic times for many
people. Macroeconomists put a lot of effort into trying to figure out what causes business cycles
and into deciding what can or should be done about them.

What causes unemployment? : Why does unemployment sometimes reach very high
levels? Why, even during times of relative prosperity, a significant fraction of the work force
unemployed?
One important aspect of recessions is that they usually are accompanied by an increase in
unemployment, or the number of people who are available for work and are actively seeking
work but cannot find jobs. Along with growth and cycles, the problem of unemployment is a third
major issue in macroeconomics.
Fig: 2 Fluctuations in Unemployment Rate in the US, 1890--1998
The best-known measure of unemployment is the unemployment rate is the number of
unemployed divided by the total labor force (the number of people either working or seeking
work). Figure 2 shows the unemployment in the United States over the past century. The highest
and most prolonged period of unemployment occurred during the Great Depression of the 1930s.
In 1933, the unemployment rate was 24.9%, indicating that about one of every four potential
workers was unable to find a job. In contrast, the tremendous increase in economic activity that
occurred during World War II significantly reduced unemployment. In 1944, at the peak of the
wartime boom, the unemployment rate was 1.2%.
Recessions have led to significant increases in unemployment in the postwar period. For
example, during the 1981-1982 recession the U.S. unemployment rate reached 10.8%. Even
during periods of economic expansion, however, the unemployment rate remains well above
zero. In 1999, after eight years of economic growth with no recession, the unemployment rate
remains well above4%. Why the unemployment rate can remain fairly high even when the
economy as a whole is doing well is another important question in macroeconomics.

What causes prices to rise? A sustained rise in the price level in the economy over a period
of time is known as inflation. What causes inflation and what can be done about it?
Fig: 3 Consumer Prices in the US, 1800--1998
When the prices of most goods and services are rising over time, the economy is said to be
experiencing inflation. Figure 3 shows a measure of the average level of prices faced by
consumers in the United States over the past two centuries. Prior to World War II inflation usually
occurred only during wartime, such as during the War of 1812, the Civil War, and World War I.
These wartime periods inflation were followed by periods of deflation, during which the prices of
most goods and services fell.
The last significant deflation in the United States occurred during 1929-1933, the initial
phase of the Great Depression. Since then inflation, without offsetting deflation, has become the
normal state of affairs, although inflation during the final few years of the 1990s was only about
2%. Figure 3 shows that consumer prices have risen significantly since World War II, with the
measure of prices shown increasing more than sevenfold.
The percentage increase in the average level of prices over a year is called the inflation
rate. If the inflation rate in consumer prices is 10%, for example, then on average the prices of
items that consumers buy are rising by 10% per year. Rates of inflation may vary dramatically both
over time and by country, from 1 or 2 percent per year in low-inflation countries (such as
Switzerland) to 1000% per year or more in countries (such as Bolivia and Argentina in recent
years) that are experiencing hyperinflations, or extreme inflations. When the inflation rate
reaches an extremely high level, with prices changing daily or hourly, the economy tends to
function poorly. High inflation also means that the purchasing power of money erodes quickly,
which forces people to scramble to spend their money almost as soon as they receive it.

How does being part of a global economic system affect nations' economies? How do
economic links among nations, such as international trade and borrowing, affect the performance
of individual economies and the world economy as a whole?
Today every major economy is an open economy, or one that has extensive trading and
financial relationships with other national economies, (A closed economy doesn't interact
economically with the rest of the world.) Macroeconomists study patterns of international trade
and borrowing to understand better the links among national economies. For example, an
important topic in macroeconomics is how international trade and borrowing relationships can
help transmit business cycles from country to country.
Another issue for which international considerations are central is trade imbalances.
Imports are goods and services produced abroad and purchased by people in the country; exports
are goods and services produced in the country and sold to people in other countries.
For any country exports and imports need not be equal in each year. For example,
following World War I and World War II, U.S. exports outstripped U.S. imports. When exports
exceed imports, a trade surplus exists. In the 1980s, however, U.S. exports declined sharply
relative to imports, a situation that has persisted through the 1990s. This excess of imports over
exports is known as trade deficit. What causes these trade imbalances? Are they bad for the
economy or for the economies of this country's trading partners? These are among the questions
that macroeconomists try to answer.
Can government policies be used to improve a nation's economic performance? How
should economic policy be conducted so as to keep the economy as prosperous and stable as
possible?
Macroeconomic policies affect the performance of the economy as a whole. The two
major types of macroeconomic policies are fiscal and monetary policy. Fiscal policy, which is
determined at the national, state and local levels, concerns government spending and taxation.
Monetary policy determines the rate of growth of nation’s money supply and is under the control
of a government institution known as central bank. In the U.S., the central bank is the Federal
Reserve System or the Fed. In India, it is the Reserve Bank of India or the RBI.
Macroeconomic issues and problems are interconnected. For example, there is a link
between the government’s budget deficit and trade imbalance. For this reason studying one
macroeconomic question, such as effects of the government budget deficit, in isolation generally
is not sufficient. Instead, macroeconomists usually study the economy as a complete system,
recognizing that changes in one sector or market may affect the behaviour of the entire economy.

The most important characteristic of capitalism is commodity production, i.e., production
not for the direct use of the producer but for the market. In this sense, any product or service
made by the producer for his own use is not a commodity. Therefore, there is an essential social
distinction between a 'commodity' and a 'product'. Thus, the bread baked by a baker for the use
of his own family is only a product; but the bread that is baked for selling in the market is a
commodity.
The capitalist economy is predominantly a system of production of commodities by means
of commodities. Virtually everything is produced for the market, with only a very negligible part of
the total production retained for self-consumption by the producer. At the same time, the inputs
needed for production of commodities and services are also bought almost entirely from the
market. Thus, the baker buys his wheat and his fuel from the market to bake his bread instead of
producing all these items of input himself. This makes him a buyer of commodities like wheat and
coal on the one hand; but on the other hand, he is also the producer of a commodity, namely
bread, which he sells in the market. This is precisely what is meant by production of commodities
by means of commodities, resulting in an impersonal market where exchange of commodities
take place with each producer generally having the dual role of both a buyer and a seller of
commodities in the market.
A capitalist producer is not only engaged in commodity production, but also buys labour
services along with other material inputs as commodities from the market. Therefore, capitalist
production entails production of commodities by means of commodities, in which labour service
like any other commodity is also bought and sold in the market.
Whatever is bought and sold in the market has to have a price. Labour service, being a
commodity like any other under capitalistic production is also bought and sold in the market at a
'price'. This price is the wage rate for labour service. Like labour, all other inputs are purchased
from the market at their respective prices such as interest for capital, rent for land etc. These
constitute factor incomes. Incomes are paid out to factors of production that are employed by
firms to produce goods and services. This output is then put on the market for people to buy.

We start by looking at how economists measure income. For this purpose we employ a
preliminary model of the economy: the continuous circular flows. We shall develop this model in
stages.
C i r c u l a r F l o w i n a B a r t e r E c o n o m y :
Suppose there are only two sectors, households and firms, in a very simple economy. In an
economy without money — economists call this a barter economy - households and firms would
interact through a continuous flow of real transactions. Households furnish firms with labour (and
usually also capital goods like machines and buildings, or land). Firms use these factors of
production, or resources, to produce goods (and services). These goods flow back to the
households, constituting compensation for having supplied the factors of production. This
Figure 4: Circular Flow in a Barter Economy
is shown in Figure: 4. The circle shows that households furnish firms with production factors such
as labour, and receive goods and services produced by firms in return.
C i r c u l a r F l o w i n a M o n e y E c o n o m y w i t h o u t s a v i n g s a n d
i n v e s t m e n t , g o v e r n m e n t a n d f o r e i g n s e c t o r :
In modern economies, firms pay households with money for using the factors of
production. Therefore, in the upper half of the graph given in Figure 5, an appropriate amount of
money flows back to the households, completing this transaction. The outer circle shows that the
inner real flow of labour and goods is financed by a monetary flow of income payments from firms
to households and of households' spending on the firms' goods.
In the lower half, households spend their money incomes on the goods produced and put
on the market by the firms. So in the end the counter-clockwise circular flow of real transactions
between households and firms remains intact. It is now complemented by an outer circle flowing

clockwise which records the payments streams that compensate for the goods received and for
the labour provided.
Figure 5: Circular Flow in a Money Economy
The outer circle has an important advantage over the inner one: it is easier to measure.
since all transactions are denominated in the same measuring units. This is not true for the inner
circle. Typically, both the factors of production and the goods produced are very heterogeneous
and cannot simply be added up. Economists therefore focus on the outer circle of income and
spending to measure aggregate economic activity.
An important point to note is that one person's spending - flowing from right to left in the
lower part of the outer circle - is another person's income, received after completion of the upper
part of the outer circle. So all spending must add up to the same amount to which all incomes add
up. Total production or aggregate output, the value of all goods and services produced by firms'
may therefore be measured either by adding up all incomes or by adding up all expenditures.
C i r c u l a r F l o w i n a M o n e y E c o n o m y w i t h s a v i n g a n d
i n v e s t m e n t b u t w i t h o u t g o v e r n m e n t a n d f o r e i g n s e c t o r :
Figure 5 provided a very simple circular flow of income in the economy. In reality, there
are a number of complicating factors. For example, consumers may not, and typically do not,
spend all their income. As Figure 6 illustrates, if households save part of the income that they
receive from firms, income leaks out of the circular flow. If firms buy investment goods that are
not directly being financed out of current income, spending is injected into the circular flow.
Figure 6, with its focus on bringing savings and investment into the picture, illustrates how the
basic circular flow model may be adapted to take into account complications that arise in reality.

Figure 6: Circular Flow with Savings and Investment—Leakages and Injections
C i r c u l a r F l o w i n a M o n e y E c o n o m y w i t h s a v i n g a n d
i n v e s t m e n t , g o v e r n m e n t a n d f o r e i g n s e c t o r :
We now take a big step and introduce all those leakages and injections that play
prominent roles in macroeconomy. First, income received by households may not arrive at the
firms as demand for three main reasons:
1 People save. If people save part of their income, their consumption expenditures fall short of
what they have produced and received as income. Saving may thus be viewed as a leakage of
income out of the circular flow system.
2 Governments levy taxes. The taxes that governments levy on citizens are a part of income
which is prevented from turning into demand – another leakage.
3 People buy foreign goods. Income earned at home which is used to buy goods produced in
a foreign country constitute a third leakage of income from the domestic circular flow system.
But there is also more than one reason why demand from outside the circular flow may be
directed towards domestic output. In fact, each of the leakages described above has a
counterpart representing an injection into the circular flow:
1 Firms invest. Firms build or buy new production facilities, new machines, distribution
networks and so on. These investments are typically financed via credit from banks or credit
markets in general.
2 Government spending. Government spending on such things as public consumption,
infrastructure or transfers represents an injection from the outside into the income circle.

3 Foreigners buy our goods. If residents of foreign countries decide to buy domestically
produced goods, this represents a last injection of demand into the circular flow.
Figure 7: Circular Flow in an Open Economy with Government--Leakages out of and injections to
circular flow of income.
Figure 7 depicts the improved circular flow of income that allows for these six categories of
leakages and injections. Note that we build on the outer, clockwise flow of income and spending
introduced in Figure 5 and refined in Figure 6. For the sake of clarity we will now refrain from
identifying firms and households in the circle.
Leakages of spending are shown in the upper part of the 'circle', injections of spending in
the lower part. Only if the sum of all leakages equals the sum of all injections does total
expenditure (measured at the end of the lower leg of the circle) exactly match total income
(measured at the outset of the upper leg). But would leakages always match injections? The
answer is yes. When we add everything up, leakages and injections always match.
Suppose that initially, with the amount of investment planned by firms, injections would
fall short of leakages. Then spending tends to fall short of supplied output, and firms must add
unsold output onto their existing stock of inventory. Whether they like it or not. they are being
forced to 'demand' that part of output themselves which they cannot sell. In the opposite case, if

demand exceeds output, either firms must draw down their existing inventory, or, if that is nor
feasible, that part of demand which exceeds supply remains unsatisfied.
Now let investment not only be the purchase of machines, but also the addition of stocks
of inventory. This is also known as ex-post investment. ‘Ex-post’ investment is ‘realised
investment’. It includes not only ‘intended’ investment in new capital goods, but also ‘unintended’
investment in inventory. ‘Intended’ investment is what is called ‘ex-ante’ investment. Then the
forced changes of inventory described above always render investment just enough to make
injections equal to leakages. So the bottom line is that, if investment is understood to include
inventory changes, the leakages and injections always balance, and the following equation holds
at all times:
(S – I) + (T –G) + (M – X) = 0
Here, (S – I) is domestic private net savings; (T – G) is public net savings or budget surplus; (M --
X) are net imports, the country’s balance of trade with the rest of the world.
Related Results:
From the above equation, we can derive some interesting results:
a) Aggregate net savings in an open economy must be equal to economy’s export surplus.
b) Government’s budget deficit must be equal to the sum of domestic private savings and net
exports.
c) If private investment is just equal to private savings in the economy, government
expenditure must be equal to the sum of aggregate tax revenue and net imports.
d) If the government budget is in balance, aggregate private investment in the economy is
just equal to the sum of aggregate savings and country’s net imports.

CU M Com-MEBE-MOD-1-National Income Accounting-Lecture-1

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