ECO152: Macroeconomics

Chapter 1: Basic concepts, relationships and issues

Introduction
• Economics: Science of household management
• How do households (individuals, households, firms or nations) make decisions
regarding scarcity?
• Scarcity: Unlimited wants, but limited means
• Scarcity necessitates choice
• Choice entails opportunity cost
• Opportunity cost:
• Value to the decision maker of the best alternative forgone (could have been
chosen but was not chosen)
Opportunity cost example: CORE Chapter 3
• Imagine that an accountant and an economist have been asked to report the cost
of going to a concert, A, in a theatre, which has a $25 admission cost. In a nearby
park there is concert B, which is free but happens at the same time.
• Accountant: “The cost of concert A is your ‘out-of-pocket’ cost: you paid $25 for a
ticket, so the cost is $25.”
• Economist: “But what do you have to give up to go to concert A? You give up $25,
plus the enjoyment of the free concert in the park. So the cost of concert A for
you is the out-of-pocket cost plus the opportunity cost.”
• Suppose that the most you would have been willing to pay to attend the free
concert in the park (if it wasn’t free) was $15. The benefit of your next best
alternative to concert A would be $15 of enjoyment in the park. This is the
opportunity cost of going to concert A. The out-of-pocket cost of an action, plus
the opportunity cost. So the total economic cost of concert A is $25 + $15 = $40.
• Opportunity cost is a way of thinking. It takes practice.
Microeconomics vs Macroeconomics
• Micro implies small
• Microeconomics focuses on individual parts of the economy
• Individual consumers, households, firms
• Utility, prices of products
• Macro implies big (‘big picture’)
• Macroeconomics focuses on the economy as a whole
• Studies the total (or aggregate) economic behaviour
• Production, price index
The mixed economy
• Three central questions each country must solve:
1. What goods and services must be produced and in what quantities?
2. How should each of the goods and services be produced?
3. For whom should the goods and services be produced?
• Three mechanisms to solve these questions:
1. Traditional: same goods produced and distributed in same way by each
successive generation --- no innovation
2. Command: State makes decisions
3. Market: Market mechanism drive decisions
CORE: Chapter 1
• Capitalism: An economic system where the focus lies on private
property rights
• Centrally planned: An economic system where the government
controls production, etc
• DO NOT confuse with political systems e.g.
• COMMUNISM is not an economic system, but a political system, functioning
under a single dominant political party
Major flows in the economy
• Production, income and spending/expenditure: flow variables
(measured over a period of time)

• Essence of economic activity is

production
• Aim of production is to
use/consume products to satisfy
wants
• Production creates income, which
is spent to purchase products
Production
• Factors of production
• Natural resources – quality vs quantity
• Labour (L) – skills, human capital
• Capital (K) – used to transform natural
resources
• Entrepreneurship – takes risks
• Technology (5th FoP)
Income
• Flipside of production: creates income
• Reward to factors of production
• Rent to natural resources
• Wages and salaries to labour
• Interest to capital
• Profit to entrepreneurship
Spending
• Income is spent to satisfy wants
• By all sectors of the economy
• Consumption expenditure by households (C)
• Investment (capital) expenditure by firms (I)
• Government spending (G)
• Foreign sector spending: exports (X) – imports (Z)
In reality, production, income earned and spending happen simultaneously.
Circular flows: goods and services, FoP
• Two markets: goods market and factor market
• Who are the buyers and sellers in each?
• Circular flow of goods and services

What is a market?

A place where buyers

and sellers meet and
trade goods and
services.
Circular flows: goods and services, FoP
• The circular flow of goods and services
through the goods and factor market
between households and firms.

• Households sell factors of production in the

factor market to firms; firms buy factors of
production from households in factor
market.

• Firms sell goods and services in the goods

market primarily to households;
households buy goods and services from
firms in the goods market.
Circular flow: income and spending
• The flow of income and
spending happens in
reverse order to that of
goods and services.

• Firms spend on factors

of production – income
which goes to
households; households
spend on goods and
services – income that
goes to firms.
Adding the government
Injections into (or additions to)
circular flow:
• Government spending on
goods and services

Withdrawals or leakages from the

circular flow:
• Taxes
Adding the financial

Injections into (or additions

to) circular flow:
• Investment
spending/capital
formation
institutions

Withdrawals or leakages
from the circular flow:
• Saving
Circular flow with all
• Exports >>
injection into
circular flow
of income and
main elements
spending.

• Imports >>
leakage or
withdrawal
from the
circular from
of income and
spending.
Macroeconomic theory
• Simplification, abstraction, model
• Assumptions
• Purposes:
• Explanation
• Prediction
• Policy
Macroeconomic policy
• Five key objectives
1. Full employment/low stable unemployment
2. Balance of payments stability/external stability
3. Economic growth
4. Equitable/socially acceptable distribution of income
5. Price stability/low stable inflation
Instruments of macroeconomic policy
• Monetary policy
• Interest rate – cost of borrowing
• South African Reserve Bank (SARB)
• Main aim: low and stable inflation
• Fiscal policy
• Taxes and government spending
• Central government
• Other: industrial policy, labour market policies, trade policies
BEWARE! Things to watch out for
• Fallacy of composition: What is true for the single case is not
necessarily true for the whole
• E.g. leaving early for work to avoid traffic gets you to work earlier, but if
everyone leaves early… is everyone going to get to work earlier?
• Correlation is not equal to causation
• E.g. more people die on bowling greens than any other sport, therefore can
one conclude that bowls is the most dangerous sport???
• Real versus nominal values: Read Box 1.2 on page 10.
BEWARE! Things to watch out for
• Distinguish between stocks, flows and ratios
• Production, income and spending are all flow variables – measured over a
period of time; this is different from stock variables which is measured at a
particular point in time (Rand/$ exchange rate on a particular day).
• Read Box 1.3 on page 17 (percentages and percentage changes)
• Do not confuse levels with rates of change
• E.g. if inflation rate has declined, it can lead one to think prices have declined,
but actually prices are still on the increase, but at a slower rate
E.g. inflation in 2008 was 9%, inflation 2009 was 7%.