Unit 3.1 - Basic Concept of Macroeconomics

 Concept of Macroeconomics

In the past day, the whole economic concept was taken as a single theory. But, in the modern period of time, it has been divided into two parts: microeconomics and macroeconomics. 

These two concepts of economics were first introduced by Ragnar Frisch in 1933 A.D. After the publication of The General Theory of Employment, Interest and Money published by J. M. Keynes in 1936 A. D., the application of macroeconomics had been taken in the history of economics. 

Meaning of Macroeconomics 

The term 'macro was derived from Greek word 'Makros', meaning is large or big. It deals with the determination of national income and employment. So, it is also called income theory as well. It is also taken as a study of these factors which help to determine the level of aggregate production, saving, investment, employment and prices in an economy and their rate of change over time. It deals with functioning of an economy as a whole. 

In conclusion, macroeconomics attempts to deal with the big issues of economic life, full employment or unemployment, capacity or under capacity production, satisfaction or unsatisfactory rate of growth, inflation and price level stability. 

Definition of Macroeconomics

According to Gardener Ackley, "Macroeconomics is the study of the forces or factors that determine the level of aggregate production, employment and price level of an economy and their rate of change over time."

In the words of K. E. Boulding, "Macroeconomic deals not with individual quantities but with aggregate of these quantities, not with individual incomes but with national income, not with individual prices but with price level, not with individual output but with national output." 

Importance of Macroeconomics

1. Formulation of Macroeconomic Policies

Macroeconomic policies like fiscal policy, monetary policy, investment policy, aggregate saving policy, aggregate tax policy etc. are formulated in macro concepts which are mostly used for the development of the nation. 

2. Measurement of National Income

Macroeconomics is used to calculate and measure the national income. It has been also used to study about the components of national income like GDP GNP and PCI of an economy. With the help of macro concept, we can analyze the concept of national income. 

3. Helps to Remove the Social Problems

Macroeconomics helps to study and analyze the various social problems like unemployment, poverty, inequality in the nation by making the overall study upon these matters. It may help to solve or remove from the society. 

4. Economic Stability

By making and formulating the different kinds of macroeconomic policies like fiscal and monetary policies, it may help to make economic stability in the nation. 

Scope of Macroeconomics

1. Theory of National Income (NI)

Various concepts of NI, methods of measuring NI, difficulties in measuring NI, social accounting (systematic records and presentation of NI

2. Theory of Employment

Problems of employment & unemployment, types of unemployment, causes & consequences of unemployment, determinants of employment (aggregate demand, aggregate supply, saving, investment, money supply)

3. Theory of Money

Demand and supply of money, Impact on employment due to change in money demand and money supply, theory of money, bank and financial institutions

4. Theory of General Price Level

Determination of and change in price level, inflation, deflation

5. Theory of Economic Growth

Economic growth, economic development, monetary policy, fiscal policy

6. Theory of International Trade

Balance of trade, balance of payment, free trade, protectionism 

Closed and Open Economy

On the basis of economic relationship or participation in international trade and finance, we can divide economies of the world into two types which are: (1) closed economy (2) open economy

Closed Economy

An economy which does not participate in international trade and finance is called closed economy. In other words, a closed economy is that which trades only within its own border and does not get involved in import and export of goods and services. 

Such type of economy is completely self-sufficient and often backward or underdeveloped because such economy has to depend on the raw materials, skills, and technology, which are available within the country. Similarly, in such type of economy government influences the level of economic activities in various ways like fiscal policy, monetary policy, trade policy, employment policy etc. The concept of closed economy is only theoretical because such economy is not in existence in the real world. All the countries of the world are involved in external trade i.e. export and import. Self-sufficiency is not possible in the modern world. 

According to N. G. Mankiew, "closed economy is an economy that does not interact with other economies of the world". 

P. A. Samuelson and W. D. Nordhaus define closed economy as, "An economy that does not engage in international trade (i.e. imports and exports) of goods and services with other countries." 

Features of Closed Economy

1. Basically, it consists household, business and government sector.
2. In such type of economy, there is government intervention and government plays the most important role than other sectors. 
3. A closed economy has no economic relation with rest of the world. 
4. It neither imports goods and services from foreign countries nor exports goods and services to the foreign countries. 
5. It neither borrows from the foreign countries nor lends to the foreign countries. 
6. It neither takes foreign aid nor gives aid to the other countries. 
7. A citizen of a closed economy can not go the the other countries to work and foreigners are also not allowed to work in the domestic territory of the closed economy. 
8. Since income received from abroad and income paid to foreigners are zero, GDP and GNP of the closed economy are equal. 

Types of Closed Economy

(A) Two-Sector Economy

The closed economy which consists of only household and business sectors is called two-sector economy. There are no government and foreign sector (import and export) in the two sector economy. This is totally hypothetically concept. In this economy, GDP is the sum of consumption expenditure made by household sector and investment expenditure by the business sector. Symbolically, 

GDP = C + I

Above diagram shows the economic transaction among the household and business sector. In two-sector closed economy, business sector receives the factor of production (land, labor, capital, organization) from household sectors and pays price for factor of production in the form of rent, wage, interest and profit to the household sector. 

In closed economy, we assume that all the saving of household comes in to the bank and financial institutions (BFIs) and business sector can borrow for investment in capital goods. 

(B) Three-Sector Economy

The closed economy which consists of household, business and government sectors is called three-sector economy. There is no foreign sector (import and export) in the three-sector economy. This is also a hypothetical concept. In this economy, GDP is the sum of consumption expenditure made by household sector, investment expenditure made by the business sector and government expenditure made by government sector. Symbolically, 

GDP = C + I + G

Above diagram shows the economic transaction among the household, business and government sector. In closed economy, household are paid for their factor services in the form of wages, salaries and transfer payment and government receives the direct taxes from households. 

Similarly, government imposes to the both direct and indirect taxes to the business sector. Instead of it, government provides some types of subsidies to the business sector. 

In three-sector closed economy, business sector receives the factor of production (ld, lb, K, org) from household sector and pays price for factor of production in the form of rent, wage, interest and profit to the household sector. 

In closed economy, we assume that all the saving of household comes into bank and financial institutions and business sector can borrow for investment in capital goods. 

Open Economy

An economy which participate in international trade and finance is called open economy. In other words, an open economy is that which trades not only within its own border but also involved in import and export of goods and services. Such type of economy is also known as four-sector economy because this economy consists of four sectors: HHS, BS, GS and FS. Symbolically, 

GDP = C + I + G + (X-M)

In the modern era, all economies of the world are open economies. These economies are interdependent with each other. They import and export raw materials, labor, technology, capital, etc. No country in the world can be self-dependent. The degree of openness of the economies is increasing due to increasing globalization of the world. The degree of openness of a country is measured by the ratio of volume of trade and GDP. 

According to N. G. Mankiew, "Open economy is an economy that interacts freely with other economies around the world". 

P. A. Samuelson and W. D. Nordhaus define open economy as, "An economy that engage in international trade (i.e. imports and exports) of goods and capital with other countries". 

Features of Open Economy

1. Basically, it consists household, business, government and foreign sector. 
2. An open economy has economic relation with the resto of the world. 
3. An open economy imports and exports goods and services from the foreign countries. 
4. Limited intervention of government has been existed in open economy. 
5. It borrows from the foreign countries and also lends to the foreign countries. 
6. An open economy takes foreign aid and also gives aid to the other countries. 
7. A citizen of an open economy can go to the other countries to work and foreigners are also allowed to work in the domestic territory of the open economy. 
8. Since citizens of the open economies receive income from abroad and pay income to the foreigners, GDP and GNP of the open economy are different. 

In such type of economy, exports are an injections or inflows to the domestic economy or create income for domestic economy. On the other hand, imports are leakages or outflow for the domestic economy. 

The HHS exports the capital and manpower and receives the factor payments as a form of remittance in terms of FOREX which is assumed as injection for the domestic economy. On the other hand, BS exports goods and services to the foreign sector and makes receipts are assumed as injection for the domestic economy. Similarly, the BS imports capital goods, raw materials etc. and makes payment is assumed as leakage or outflow for the domestic economy. 

Likewise, the government sector also makes the receipts from foreign sector as injection or inflow for domestic economy. Similarly, if the government makes payments to the foreign sector are assumed as leakages or outflow of domestic economy. 

Difference Between Open and Closed Economy

Basis	Open Economy	Closed Economy
1.      Economic Relation with rest of the world	Yes	No
2.      Import & Export	Involved	Not Involved
3.      Borrowing & Lending	Yes	No
4.      Foreign Aid	Takes & Gives	Neither Takes nor Gives
5.      Movement of Labor	Allows Inward & Outward Movement	Does Not Allow Inward & Outward Movement
6.      Remittance	Receives	Does Not Receive
7.      Realistic or Theoretical	Realistic	Theoretical
8.      Equality between GDP & GNP	Different	Equal
9.      Role of the Government	Limited	Dominant

Macroeconomic Variables

Macroeconomic variables are the indicators which shows current trend or status or behavior of an economy. Major macroeconomic variables are as follows: 

1. Aggregate Demand and Aggregate Supply

The aggregate demand refers to the quantity of goods and services that household, firms, government and customers abroad want to purchase at each price level. Whereas, the aggregate supply refers to the quantity of goods and services that firms choose to produce and sell at each price level. 

2. Gross Domestic Product (GDP)

It is defined as the money value of final goods and services produced within a nation during a year. In other words, GDP is a money value earned by all people living within the boundary of the nation whether they are domestic people or foreigners. Symbolically, 

GDP = C + I + G + (X-M)

GDP↑⟶ Good performance of the nation and vice-versa

3. Gross National Product (GNP)

It is defined as the money value of all final goods and services produced within a nation during a year plus net factor income from abroad (NFIA). It is assumed as a broad concept than GDP. 

NFIA is the income earned by the domestic people living in abroad minus income earned by foreigner in domestic nation. In case of Nepal, it would be the difference between the earning of Nepalese people living in abroad and the the earning of foreigners living in Nepal during a year. Symbolically, 

GNP = GDP + NFIA

GNP↑⟶ Good performance of the nation and vice-versa

4. Per Capita Income (PCI)

It is an average income of any nation or income earned by an individual during a year. It is derived by dividing the national income of a country by it's total population in a given period of time. It is usually measured in dollar. Symbolically, 

PCI = NI (2020) / Total Population (2020)

PCI↑⟶ Good performance of the nation and vice-versa

5. Economic Growth Rate

Economic growth rate is defined as the rate at which the real GDP of a country increases over a period of time. The higher economic growth rate can be achieved by increasing the amount of factor of production and their productivity. 

Economic Growth Rate↑⟶ Good performance of the nation and vice-versa

6. Inflation

Inflation is sustained or continuous rise in general (average) price of goods and services in a given period of time. When price of goods and services rise, it reduces the value of money and it increases the cost of living of the common people. It may reduces the living standard of common people. 

Inflation↑⟶ Bad performance of the nation and vice-versa

7. Unemployment

Unemployment is a situation in which an individual person is ready to work mentally and physically at existing market wage rate but not get any job. When number of people, at the age of labor forces (in Nepal 15-60) are jobless is known as unemployment. 

Unemployment↑⟶ Bad performance of the nation and vice-versa

8. Poverty 

Poverty is the situation having insufficient resource or income for nutrition food, clothing, housing, clean drinking water, health services, education etc. 

Poverty↑⟶ Bad performance of the nation and vice-versa

9. Inequality 

Inequality is the difference in income and wealth distribution between individual among individuals, and group within the society. When there is high distance between rich and poor, the inequality also be high and vice-versa. Inequality may be in earning capacity, ability of finding job, age, condition of health, level of thinking, social values and norms and resource availability etc. Widely used measurement of inequality is Gini Coefficient, Lorenz Curve etc. 

Inequality↑⟶ Bad performance of the nation and vice-versa

10. Balance of Trade (BOT)

BOT is the monetary value of imports and exports of visible or material commodities during a year. Import and export commodities are recorded in the port or the custom offices. 

Types

1. X>M ⇒ Surplus BOT

2. X<M ⇒ Deficit BOT

3. X=M ⇒ Balanced BOT

11. Balance of Payment (BOP)

The BOP of a country is a systematic record of all economic transaction (visible and invisible items) between the residents of the reporting country and residents of foreign country during a given period of time. The BOP is merely a way of listing receipts and payments in international transactions of a country. 

12. Business Cycle (Trade Cycle)

Business cycle refers to the phenomena of cyclical (wave-like) fluctuations/deviations in the aggregate output, employment, income, price level, sales, profit, personal incomes, bank credit etc. from the equilibrium or trend line. Therefore, the business cycle is the downward and upward movement of GDP around its long-term growth trend.