THE UNIVERSITY OF LUSAKA FACULTY OF ECONOMICS, BUSINESS AND MANAGEMENT ECF110/ED230: INTRODUCTION TO MACROECONOMICS By: Keegan Chisha (BA, MSc)

Historic Background of macroeconomics Macroeconmics was born during the great depression in the USA. Gov’t wanted to fix 25% unemployment created. But also to measure the wealth of the whole economy To guide government policies to fix macro problems

Definition Macro ….. Greek word meaning ‘’Big’’ It is a study of the large economy as whole describing and explaining economic processes that concern aggregates. By contrast, microeconomics treats economic processes that concern individuals. Example: the decision of a firm to purchase a new office chair from company X is not a macroeconomic problem. However a reaction of companies to an enactment of a law that raises minimum wage. Macroeconomics investigates aggregate behavior by imposing simplifying assumptions. (‘’ assume there are many identical firms that produce the same good’’.) The assumptions are used in order to build macroeconomic models

ECONOMIC MODELS Economic models typically have three aspects, the story, the mathematical model, and a graphical representation. Macroeconomics is non experimental: like history. Macroeconomics can not conduct controlled scientific experiments ( people would complain about such experiments and with a good reason)

Motivation for macroeconomics What is the motivation of macroeconomics? Answer: Politicians should be advised how to control the economy, such that specified targets can be met optimally. Below is a list of targets that are traditionally considered: Economic growth Stable prices (limit inflation) Full employment (limit unemployment) External equilibrium Just distribution of income Public debt and Balanced budget In this course, we will analyse in detail economic growth, inflation and employment

NATIONAL INCOME An economy comprises various individual economic agents for example Households (H/H) Firms Departments of central and local government Each of these economic agents make decisions on spending Together, their individual decisions determine the economy’s total level of production of goods and services.

THE CIRCULAR FLOW To develop the circular flow assume the following No government sector No foreign sector (domestic economy has no links with the rest of the world) Households own the factors of production or inputs to the production process. i.e they own their own labor, which they can rent out to firms in exchange for wages. Note that H/H are ultimate owners of firms. It is H/H who put up the money as sole traders, partners or shareholders in exchange for the final entitlement to the firm’s profits. Although of course factors such as capital and land appear to be held by firms , they are ultimately owned by the H/H.

A summary of transactions between HH and Firms Households Firms Own factors of production (FoP) which they supply to firms Use FoP supplied by HH to produce goods and services Receive incomes from firms in exchange of supplying FoP Pay HH for use of FoP Spend on goods and services produced by firms Sell goods and services to HH

Circular Flow between HH & Firms HOUSEHOLDS FIRMS Spending on goods and services Goods and services Services of productive factors Factor incomes

Circular Flow between HH & Firms continued…. Note that the inner loop shows flow of real resources HH supply FoP which firms use to produce goods and services for HH Outer loop shows corresponding payments. Firms pay factor incomes to HH but receive revenue from HH spending on goods and services that the firms produce. The circular flow above suggests three ways to measuring economic activity in an economy. We can measure economic activity using the following; Value of the goods and services The level of factor earning which represent the value of factor of spending on goods and services. The value of spending on goods and services

Circular Flow between HH & Firms continued…. The underlying assumption above is that all payments must be spent on purchasing real resources. With that assumption we get the same estimate of total economic activity whether we measure the value of production output, the level of factor incomes, or spending on goods and services. That is; Factor incomes equal HH spending. Why? We assumed that all incomes are spend on real resources. The value of output equal total spending on goods and services. Why? We assume that all goods and services are sold. The value of output must equal the value HH income. Why? We always regard the ownership of a business or FoP is by HH. Note that since profits are residually defined as the value of output sales minus the direct cost of land, labour and capital and since profits accrue to HH who own the business, it follows that HH incomes derived from either supplying labour, land and capital or from entitlements to firms, profits must exactly equal the value of production.

Circular flow extension Our model is very simple up to this point. In what follows we ask the questions; What happens if firms do not sell all their output? What happens if firms sell output not to HH but the other firms? What happens if HH do not spend all their incomes? Even after taking into account all these possibilities, we shall see that our conclusions remain unchanged, i.e the level of economic activity can be measured by valuing total spending, total output or total earnings and all three methods give the same answer.

National Income Accounting Gross Domestic Product (GDP) is a measure of output produced by FoP located in the domestic economy regardless of who owns the factors usually in a period of one year. (Note that GDP can also be quarterly and half year). It measures the value of output produced within the economy.

National Income Accounting continued… Assume the following; Closed economy (a country with no external links with the rest of the world) Firms hire labour from HH Firms buy raw materials and machinery from other firms METHODS OF ACCOUNTING Value Added: value added is the increase in the value of goods as a result of the production process. It is calculated by deducting from the value of the firms’ output the cost of the input goods that were used up in the act of producing that output. When calculating GDP using the value added method, you have to make a distribution between intermediate goods and final goods. Intermediate goods are partly finished goods which form inputs to another firm’s production process and are used up in that process. Final goods are goods purchased by the ultimate user. They are either consumer goods by HH or capital goods such as machinery which are purchased by firms.

EXAMPLE Ice cream is a final good Steel is an intermediate good used by other firms in their production process Consider the following example … Assume four firms in the economy. A steel producer A machine producer A tyre producer A car producer who sells to HH

EXAMPLE Good Seller Buyer Transaction value Value added Exp on final goods Factor earnings Steel Steel Producer Machine Producer 1000 ----- Car Producer 3000 Machine 2000 Tyres Tyre producer 500 Cars consumers 5000 1500 Total value of transactions 11500 7000

Observations and conclusions Steel producer makes 4000 worth of steel, sells 1000 to machine producer and 3000 to car producer. Assuming the steel producer mines the iron ore from which steel is produced, then the entire 4000 is value added. The firm pays revenue directly or indirectly in wages and rents and the residual profits also accrue to HH as income. Note that although 2 firms steel and car producer have bought steel, it does not show up in the final goods and since steel is entirely an intermediate good. Machine maker spends 1000 to buy steel produced machine sold to the car maker at 2000, value added is 1000. 1000 accrues directly or indirectly to HH. Since the car producer intends to keep the machine, its full value of 2000 is shown under final expenditure.

Observations and conclusions continued…… Tyre producer produces an intermediate good which does not show under final expenditure. Assuming the tyre manufacturer also owns the rubber trees from which tyres are made, the entire 500 is value added and contributes directly or indirectly to HH incomes. Car producer spends 3000 on steel and 500 on tyres. 1500 is the value added of the car producer. The net revenue pays HH for factor services supplied or is paid to them as profits. Car producer sells car for 5000 to final consumer. The car is now final good and its full value of 5000 appears as final expenditure. Table shows gross value of all transactions is 11500 but this overstates the value of the goods the economy has actually produced. Note that 3000 that the steel producer earned by selling steel to the car producer is already included in the final value of car output. Thus double counting of (3000)

Observations and conclusions continued…… Column 5 shows value added equal to 7000 and is correct way of measuring net output of the economy. Since each producer pays out corresponding net revenue to HH as direct factor payments or indirectly as profits, HH earnings also equal 7000. We get the same answer if we measure spending on final goods and services. Final users are HH buying the cars and the car producer buying (everlasting) machinery