Steve Ouma Oyugi Macro Economics Kimathi University College of Technology

2nd Year 2nd Semester

Macroeconomics Inflation 6. Balance of payments (BOP) and [Exchange
Deflation rates] - this is an analysis of transactions of the
The Relationship between Macro and Microeconomics Reflation residents of a country with the rest of the world
Stagflation within a certain period. It takes account of imports,
Microeconomics deals with the behavior of individuals, 3. Theory of Economic Growth exports and capital exchange leading to either
consumers, factor owners, firms, individual industries and 4. Macro theory of Economic Growth supply or deficits. Exchange rate is the rate at
individual markets. which a countrys currency exchanges with
These elements are explained further as: anothers currency.
Macroeconomics on the other hand deals with a holistic
approach of the economy by dealing with various aggregates, Employments and unemployment A microeconomic approach has limitations to the extent that
which include: there it creates self confusing paradoxes. A firm will make
There are several causes of unemployment and involuntary more profits by cutting wages and thus maximizing profits.
1. Total employees unemployment. They include: This, when looked at from a macroeconomics view reduces
2. National income aggregate demand.
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 Savings
produced in a country within a year. It determines An individual or a firms saving is encouraged but at a micro
Macroeconomics tries to explain what determines the level of per capita income, also determined by the level of economic level may lead to a fall in the national income.
total National Economic activity and what causes economic physical capital, human capital and technology. Macroeconomic approach helps formulate government macro
growth. 2. General price level and inflation The classical policies and thus accelerating economic growth.
economists argued that inflation and prices was
The classical economists had the basic principle that the determined by the amount of money in circulation. Extra work
economy had self -adjusting mechanisms to remain at full Keynes introduced the demand pool theory of Advantages of Macroeconomics
employment. This was based on the JB Say laws of the inflation caused by excessive demand as can 1. Formulation and execution of economic policies by
market, which says that demand creates its own supply. happen during boom or panic buying. the government.
3. Other causes of inflation could be cost push 2. Indispensable for the study of macroeconomics,
British Economist JM Keynes (1883 1946) showed that inflation. which is necessary for studying the vast fields of
an existence of great and involuntary unemployment during 4. Economic growth this is sustained growth in factor generalizations.
the depression of 1930 created the grounds on which national incomes. Keynes concentrated mainly on 3. Indispensable for the study of microeconomics. No
macroeconomics is founded. short-term growth but we know that economic laws of microeconomics can be formulated unless
growth is a function of levels of investment. A pre-study of the aggregates bearing on it have been
Central issues in Macroeconomics certain level of economic growth is needed to made.
Macroeconomics deals with the following studies, which sustain a steady growth as explained by growth 4. Indispensable for the study of aggregate values.
makes up its scope: models. There is a clear difference between individual and
5. Stagflation this is a special form of inflation group behavior and as such what is applicable to a
1. Theory of income, output and employment. The resulting from the supply side constraints. The firm may not be true for the whole economy.
elements herein are: Keynesian economy focuses mainly on demand 5. Indispensable for guiding governments.
Theory of consumption function side constraints, but modern macroeconomists
reveal supply side constraints, which can come Disadvantage of Macroeconomics
Theory of investment function
from supply shocks. 1. The study of individual units in some cases is very
Theory of business cycle important and as such microeconomics is
2. Theory of prices whose elements are: implemented instead.
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
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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BMP decompressor
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 Kimathi University College of Technology
2nd Year 2nd Semester
Lack of specialization by household. In his model, income is a function of the level of employment
since labor is the only variable factor. The level of
Limitations of GDP as a Measure of Welfare employment is determined by aggregate supply and demand.
The GDP should factor in the number of
working hours and the conditions therein. GDP
ignores non-monetary services. Consumption Demand
GDP should measure the levels of This depends on the marginal propensity to consume and the QuickTime and a
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are needed to see this picture.
environmental degradation and the pollution level of National income.
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.
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Take note that C + I is parallel to C = a + bY, indicating that
The Aggregation of the Economy BMP decompressor
are needed to see this picture.
the level of investment is constant and does not depend on
Product Market
change in income.
Labour Market
Money Market Aggregate Supply
Bonds and Equities Market The short run level of National Income depends on Aggregate
supply and demand. Aggregate supply is composed of
The economy is divided into the above four sectors. consumer goods and services as well as capital goods.
Keynes assumed unchanging capital stock and level of
Product Market OZ is the income line technology, with labor being the only variable factor.

The equilibrium in the product market is achieved when The point beyond E represents savings of the community,
output = demand. given by the identity Y = C + S.

Y = C + I + G + (X - M) Investment Demand
This is a component of aggregate demand determined by: Keynes Criticism of Classical Economists
C in our analysis 1. Marginal efficiency of capital (Expected Rates of
Profits)
Keynesian Model of National Income Determination 2. Rate of interest

Income and Expenditure Approach Keynes assumes that investment is autonomous and does
The Keynesian is a short-term approach, which assumes that not change with the changing levels of income.
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 7th July 2010 Kimathi University College of Technology
Steve Ouma Oyugi Macro Economics Kimathi University College of Technology
2nd Year 2nd Semester
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.
QuickTime and a
BMP decompressor
National Income Y=C+I
are needed to see this picture.
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
The classical economists assumed that the equilibrium level Y = (a + Ia)/(1-b) cause of unemployment
of National Income is established at full employment and the Thus;
economy always tends towards full employment through self Y = [1/(1-b)]a+Ia in developing economies, poverty and unemployment result
adjusting mechanisms. from lack of capital, relative to labor availability.
Assuming a state of employment, corresponding to OYF level Nb: - An increase in b leads to an increase in Y Thus in developing nations, there is supply side constraint
of National Income but according to Keynes, equilibrium is resulting from lack of capital and means of production.
established at level E, which corresponds to OY level of Equation iii shows the equilibrium level of occurring where Keynes proposed such measures as increased government
National Income. This causes a level of unemployment. 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
For full employment to be achieved, investment demand must autonomous investment by the multiplier. The higher the inflationary. Dr. R. V. Rao ascertains that the Keynesian
equal RH, but at E it is only equal to EQ, therefore full marginal propensity to consume the higher the level of multiplier is inapplicable in underdeveloped/developing
employment is not always guaranteed. Full employment is not income. economies since it will lead in a rise in prices. This is because
always guaranteed because there are savers and they not the supply curve of output is relatively inelastic, therefore
necessarily invest their money. Investment in most instances rising demand would lead to inflation.
is undertaken by Entrepreneurs. 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 Kimathi University College of Technology
2nd Year 2nd Semester
It is important in understanding the multiplier since the size of This does not change with income, and this kind of
the multiplier depends on the marginal propensity to expenditure would include government investment in roads. C is the supply price of the cost of capital
consume. R is the annual expected yields of investments
Entrepreneurs base their investments on the marginal Induced Investment r is the expected rates of return of profits.
efficiency of capital, which is determined by current levels of This is investment that is affected by changes in the level of
consumption. income. Investment Demand
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; QuickTime and a
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1. Savings are needed to see this picture.

2. Debt payment
3. Precautionary and speculatory motives of holding
cash balances Equilibrium level of investment is attained where the marginal
4. Importation increase income in foreign countries efficiency of capital is equal to the current rates of interest.
5. Taxation The marginal efficiency thus represents investments.
6. Inflation Economic depression is a signal of expected marginal
efficiency of capital hence low investment demand.
The theory of the multiplier is one of the greatest contributions
of J. M. Keynes. It explains the effect of investments in an It depends upon the marginal efficiency of capital, or the Marginal efficiency of capital (shift outwards)
economy and can be used to explain the effect of investments expected rates of profits. It is also affected by the rates of Increase in demand for products leads to change in
in an economy and can be sued to explain trade cycles of interest. For an investment choice to be made, it must be level of investments
boom and depression. It normally applied by the government expected to fetch higher returns than the current market rate Change in technology and efficiency
in its physical policy to move the economy from depression or of interest. Marginal efficiency of capital in reality is a higher User cost of capital (this determines the rate of
to check inflation and unemployment through expansionary inducement for investment since the market rate of interest is return on capital)
and contractionary fiscal policies. sticky. Credit availability
Interest on the other hand is determined by liquidity Government fiscal policy (government borrowing
Investment preference and money supply. The greater the liquidity crowds out private investment)
(This is an increase in the stock of capital) preference the higher the interest rate and the greater the Government expenditure on infrastructure,
Investment is new expenditure incurred on addition of money supply the lower is the interest rate. communication, roads and security affects the
physical stock of capital e.g. machinery, plant, equipment, levels of investment.
tools and inventory. Marginal efficiency of capital
This should be differentiated from financial investment, which This is the rate of profits expected from an extra unit of capital Accelerator Principle on Investments
involves trading in shares, stocks and bonds, which is simply asset. This is determined by(depends on) the supply price or
the transfer of ownership. the cost of capital and also depends on expected yields of Post Keynesian economists argue that investments is also a
investments. function of income since an increase in income increases
Autonomous Investment
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
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