Steve Ouma Oyugi Macro Economics Kimathi University College of Technology

2nd Year 2nd Semester

Macroeconomics Inflation
Deflation
The Relationship between Macro and Microeconomics Reflation
Stagflation
Microeconomics deals with the behavior of individuals, 3. Theory of Economic Growth
consumers, factor owners, firms, individual industries and 4. Macro theory of Economic Growth
individual markets.
These elements are explained further as:
Macroeconomics on the other hand deals with a holistic
approach of the economy by dealing with various aggregates, Employments and unemployment
which include:
There are several causes of unemployment and involuntary
1. Total employees unemployment. They include:
2. National income
3. General price levels 1. National income/Gross National Product this
4. Inflation e.t.c. is the total value of all final goods and services
produced in a country within a year. It determines
Macroeconomics tries to explain what determines the level of per capita income, also determined by the level of
total National Economic activity and what causes economic physical capital, human capital and technology.
growth. 2. General price level and inflation The classical
economists argued that inflation and prices was
The classical economists had the basic principle that the determined by the amount of money in circulation.
economy had self -adjusting mechanisms to remain at full Keynes introduced the demand pool theory of
employment. This was based on the JB Say laws of the inflation caused by excessive demand as can
market, which says that demand creates its own supply. happen during boom or panic buying.
3. Other causes of inflation could be cost push
British Economist JM Keynes (1883 1946) showed that inflation.
an existence of great and involuntary unemployment during 4. Economic growth this is sustained growth in
the depression of 1930 created the grounds on which national incomes. Keynes concentrated mainly on
macroeconomics is founded. short-term growth but we know that economic
growth is a function of levels of investment. A
Central issues in Macroeconomics certain level of economic growth is needed to
Macroeconomics deals with the following studies, which sustain a steady growth as explained by growth
makes up its scope: models.
5. Stagflation this is a special form of inflation
1. Theory of income, output and employment. The resulting from the supply side constraints. The
elements herein are: Keynesian economy focuses mainly on demand
Theory of consumption function side constraints, but modern macroeconomists
reveal supply side constraints, which can come
Theory of investment function
from supply shocks.
Theory of business cycle
2. Theory of prices whose elements are:
Steve Ouma Oyugi Macro Economics 7th July 2010
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 countrys currency exchanges with
anothers 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.
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Steve Ouma Oyugi Macro Economics Kimathi University College of Technology
2nd Year 2nd Semester
2. Macroeconomics is applicable in studying This is the monetary value of goods and services
homogeneous aggregate variables only, and as produced by the normal residents and non-residents of a
such cant be applied in the context of country less the net factor incomes earned abroad.
heterogeneous variables.
QuickTime and a
3. An aggregative tendency does not influence all GDP = GNP NFI BMP decompressor
are needed to see this picture.
sectors of the economy in the same way thus
precaution has to be taken incase it happens. E.g. Note that net factor income is different from net exports
some industries may benefit more than others with and imports and thus dont form part of GNP or GDP.
an increase in the general price level.
4. Macro-analysis is fruitful when aggregate variables Net National Product
are accurately measured. However even with an This is the market value of all final goods and services
advanced statistical procedure, desirable accuracy after providing for depreciation. Identities
in the measurement of macro-economic variables is 1. Y = C + I
not possible e.g. it is not easy to accurately NNP = GNP Depreciation C-Consumption Expenditure
measure the national income of an economy. I - Investments
National Income and Factor Cost; these take into What happens to produced income which is
National Income and National Income Accounting account indirect taxes and subsidies. The difference not consumed?
between total and direct taxes and subsidies is referred It is used to increase the inventories, which is
National income is the total market value of all goods and to as Net Indirect taxes. treated as actual investments or savings.
services produced within the economy within a year. National
income is a monetary measure and takes account of final NI (factor cost) = Net National Product Indirect taxes + 2. Y=C+S
goods without intermediaries. subsidies. Putting equations 1 and 2 together produces:
C+I=C+S
National Income = National Expenditure = National Product Circular Flow of Income I=S
NB: - In a simple two sector model where there is
Gross National Product This is a very simple model showing the working of the no government intervention or foreign trade;
This refers to the value of goods and services produced by economy, depicting movements of resources between the
the residents of a country, whether locals or foreigners. This producers and consumers. Savings = Investments
constitutes: It shows how income moves from one sector of the economy
to another in a series of monetary movements. Three Sector Model of Circular Flow of Income (Open
1. Value of goods and services produced and Model)
consumed by the consumers (C). Two-Sector Model of Circular Flow of Income (Closed
2. New capital goods plus inventories, not sold during Economy) In this model, the government is included. The intervention of
a year (I). the government involves:
3. Goods and services from the government (G). In a simple microeconomic model, we assume that there is no i) Taxation
4. Net exports (X-M). government intervention and no foreign trade. In this case, ii) Government Expenditure
Y=C+I+G+(X-M) the value of the Output Y Produced = the value of Output iii) Government Borrowing
5. Net factor income which the difference between net sold.
factor incomes such as wages.

Gross Domestic Product

Steve Ouma Oyugi Macro Economics 7th July 2010 Kimathi University College of Technology
Steve Ouma Oyugi Macro Economics Kimathi University College of Technology
2nd Year 2nd Semester
Precautions to take when using the value
added method
The value of self occupied houses should be
included.
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2nd hand goods are excluded
are needed to see this picture. Production for self consumption should be
included
Services from housewives is normally omitted
due to complications that arise in computation.

NI Identity 2. Income method

1. Y = C + I + G + (X - M) The NI is obtained by summing up the incomes of
Identities Where (X - M) = Xn all individuals of a country. This constitutes rent
The National Income Identity = Total expenditure 2. Y = C + I + G + Xn from land, interest on capital, wages and salaries
1. Y = C + I + G But and profits from entrepreneurs.
Y=C+S+T
Total income consumed, saved and taxed.
3. Expenditure method
2. Y = C + S + T Thus Involves adding up all the expenditures made on
3. I + G + Xn = S + T goods and services within 1 year. This expenditure
Since;
is on the consumer goods and services by
The meaning of equation 3 is that the total private individuals and households denoted by (C), the
Y= E (Expenditure) investments + government expenditure + net export = savings government expenditure denoted as (G),
+ Net Revenue expenditure on the capital goods and inventories
3. C+I+G=C+S+T
denoted as (I) and Net Export Expenditure denoted
4. G - T (Deficit/Surplus) = S - I Measuring the National Income at (X - M) where (X - M) is Xn.
Ways;
Equation 4 explains the government budget deficit. If the 1. Value added method GDP = C + I + G + Xn.
government expenditure exceeds the tax collected, then there This divides the economy into sectors such as
would be a budget deficit. To finance this deficit, the fishing, mining, agriculture, transport, industry, Difficulties in measuring National Income
government borrows from the financial market and this manufacturing e.t.c. We then calculate the net value
reduces private investment hence government borrowing Treatment of non-monetary transactions e.g.
added by each sector at factor cost and market housewives services and household
crowds out private investment. price. In order to obtain the net value, we subtract consumption.
the cost of intermediaries (raw materials used to Treatment of government activities like
National Income Identity in a 4 Sector Model produce the end product, capital depreciation) but defense, social services like free education
add the net factor income from abroad. and medication.
In a 4-sector model, we introduce trade but we assume that it
NB: - NI or Net National Product = NDP (fc) + NFI. Activities of foreign firms and profit repatriation.
is only the business firms that interact with the foreign
countries. Where fc means at factor cost. NB: - Income from foreign firms is introduced
4 sector Models Significance of the value added method and treated as National Income yet we know
The method reveals the performance of the that it ends up back in their countries.
sector. Lack of accurate record keeping particularly by
the households.

Steve Ouma Oyugi Macro Economics 7th July 2010 Kimathi University College of Technology
Steve Ouma Oyugi Macro Economics
2nd Year 2nd Semester
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
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.
Steve Ouma Oyugi Macro Economics
Kimathi University College of Technology
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 QuickTime and a
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are needed to see this picture.
level of National income.
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Take note that C + I is parallel to C = a + bY, indicating that
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are needed to see this picture.
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
OZ is the income line technology, with labor being the only variable factor.
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: Keynes Criticism of Classical Economists
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.
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Steve Ouma Oyugi Macro Economics
2nd Year 2nd Semester
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are needed to see this picture.
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.
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Keynes Analysis of a 2 Sector Model (Keynesian S = Y a bY
Multipliers) = -a + Y bY
= -a + Y(1 b)
We assume that there isnt government taxation and
expenditure and we are dealing with a closed economy. 1 b is the marginal propensity to save. If the level of savings
is very high then the level of multiplier increases too.
National Income Y=C+I
Consumption C = a + bY Relevance of Keynesian Analysis in Respect to
Investment I = Ia (Investment is Developing Countries
autonomous)
Thus; Keynes put forward a theory of income and employment,
Y = (a + bY) + Ia which explains the determination of income and employment
Y = a + bY + Ia through the aggregate demand and supply.
Y bY = a + Ia ***Keynes, at a time of economic depression (1930s) in
Y(1 b) = a + Ia Europe, where the level of aggregate demand was the main
Y = (a + Ia)/(1-b) cause of unemployment
Thus;
Y = [1/(1-b)]a+Ia in developing economies, poverty and unemployment result
from lack of capital, relative to labor availability.
Nb: - An increase in b leads to an increase in Y Thus in developing nations, there is supply side constraint
resulting from lack of capital and means of production.
Equation iii shows the equilibrium level of occurring where Keynes proposed such measures as increased government
Aggregate Demand is equal to aggregate supply. expenditure as a remedy for Europe.
The level of equilibrium Y can be obtained by multiplying the If this is applied in developing countries it is going to be
autonomous investment by the multiplier. The higher the inflationary. Dr. R. V. Rao ascertains that the Keynesian
marginal propensity to consume the higher the level of multiplier is inapplicable in underdeveloped/developing
income. 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.
Savings Investment Approach Application of Consumption Function

There may also be several other reasons for saving such as Y=C+S Aggregate demand and supply cannot fully explain full
to provide for education and contingencies, holidays and even C=YS employment and for employment to exist savings must equal
at old age and retirement. Therefore savings may not be Y=YS+I investments failure to which we experience involuntary
equal to investments, this results to a level of unemployment. Thus; unemployment.
S=I Marginal propensity to consume explains the consumption
The level of investment depends upon the marginal efficiency But Y = C + I; thus I = Y C changes. Consumption changes at a lower rate than increase
of Capital, which is the main motivation for investment. i.e. if Yet C = a + bY in income.
the expected rates of profits are not favorable, then people Therefore: - However, to obtain Y = (I + a)/(1-b) In order to maintain a certain level of income and employment
are not able to invest. C=YS then since S=I from iii the gap between income and consumption should be
a + bY = Y S I=Y a - bY matched by investment to prevent unemployment.
Thus Y=I + a + bY
Steve Ouma Oyugi Macro Economics 7th July 2010 Kimathi University College of Technology
Steve Ouma Oyugi Macro Economics
2nd Year 2nd Semester
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 doesnt 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
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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.
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efficiency of capital is equal to the current rates of interest.
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.
7th July 2010
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
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
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Steve Ouma Oyugi Macro Economics Kimathi University College of Technology
2nd Year 2nd Semester
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.
Money

Steve Ouma Oyugi Macro Economics 7th July 2010 Kimathi University College of Technology