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Steve Ouma Oyugi
2nd Year 2nd Semester
Macro Economics
1. Theory of income, output and
The Relationship between Macro and
Microeconomics deals with the behavior of
individuals, consumers, factor owners, firms,
individual industries and individual markets.
Macroeconomics on the other hand deals
with a holistic approach of the economy by
dealing with various aggregates, which
Total employees
National income
General price levels
Inflation e.t.c.
employment. The elements herein
• Theory of consumption
• Theory of investment function
• Theory of business cycle
2. Theory of prices whose elements
• Inflation
• Deflation
• Reflation
• Stagflation
3. Theory of Economic Growth
4. Macro theory of Economic Growth
These elements are explained further as:
Macroeconomics tries to explain what
determines the level of total National
Economic activity and what causes
economic growth.
The classical economists had the basic
principle that the economy had self
-adjusting mechanisms to remain at full
employment. This was based on the JB Say
laws of the market, which says that
demand creates its own supply.
British Economist JM Keynes (1883 –
1946) showed that an existence of great
and involuntary unemployment during the
depression of 1930 created the grounds on
which macroeconomics is founded.
Central issues in Macroeconomics
Macroeconomics deals with the following
studies, which makes up its scope:
Steve Ouma Oyugi
Kimathi University College of Technology
Macro Economics
Employments and unemployment
There are several causes of unemployment
and involuntary unemployment. They
1. National income/Gross National
Product – this is the total value of all
final goods and services produced in
a country within a year. It
determines per capita income, also
determined by the level of physical
capital, human capital and
General price level and inflation
– The classical economists argued
that inflation and prices was
determined by the amount of money
in circulation. Keynes introduced
the demand pool theory of
inflation caused by excessive
demand as can happen during boom
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or panic buying.
3. Other causes of inflation could be
cost push inflation.
4. Economic growth – this is
sustained growth in national
incomes. Keynes concentrated
mainly on short-term growth but we
know that economic growth is a
function of levels of investment. A
certain level of economic growth is
needed to sustain a steady growth as
explained by growth models.
5. Stagflation – this is a special form
of inflation resulting from the supply
side constraints. The Keynesian
economy focuses mainly on demand
side constraints, but modern
macroeconomists reveal supply side
constraints, which can come from
supply shocks.
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 country’s
currency exchanges with another’s
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.
Kimathi University College of Technology
Steve Ouma Oyugi
2nd Year 2nd Semester
Macro Economics
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
2. Indispensable for the study of
macroeconomics, which is necessary
for studying the vast fields of factor
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
Disadvantage of Macroeconomics
1. The study of individual units in some
cases is very important and as such
microeconomics is implemented
2. Macroeconomics is applicable in
studying homogeneous aggregate
variables only, and as such cant be
applied in the context of
heterogeneous variables.
Steve Ouma Oyugi
Macro Economics
Kimathi University College of Technology
3. An aggregative tendency does not
influence all sectors of the economy
in the same way thus precaution has
to be taken incase it happens. E.g.
some industries may benefit more
than others with an increase in the
general price level.
4. Macro-analysis is fruitful when
aggregate variables are accurately
measured. However even with an
advanced statistical procedure,
desirable accuracy in the
measurement of macro-economic
variables is not possible e.g. it is not
easy to accurately measure the
national income of an economy.
National Income and National Income
National income is the total market value
of all goods and services produced within
the economy within a year. National income
is a monetary measure and takes account of
final goods without intermediaries.
National Income = National Expenditure =
National Product
Gross National Product
This refers to the value of goods and
services produced by the residents of a
country, whether locals or foreigners. This
1. Value of goods and services
produced and consumed by the
consumers (C).
2. New capital goods plus inventories,
not sold during a year (I).
3. Goods and services from the
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government (G).
4. Net exports (X-M).
5. Net factor income which the
difference between net factor
incomes such as wages.
Gross Domestic Product
This is the monetary value of goods and
services produced by the normal
residents and non-residents of a country
less the net factor incomes earned
Note that net factor income is different
from net exports and imports and thus
don’t form part of GNP or GDP.
Net National Product
This is the market value of all final goods
and services after providing for
NNP = GNP – Depreciation
National Income and Factor Cost;
these take into account indirect taxes
and subsidies. The difference between
total and direct taxes and subsidies is
referred to as Net Indirect taxes.
NI (factor cost) = Net National Product –
Indirect taxes + subsidies.
Circular Flow of Income
This is a very simple model showing the
working of the economy, depicting
movements of resources between the
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Steve Ouma Oyugi
2nd Year 2nd Semester
Macro Economics
producers and consumers.
It shows how income moves from one sector
of the economy to another in a series of
monetary movements.
Two-Sector Model of Circular Flow of
Income (Closed Economy)
In a simple microeconomic model, we
assume that there is no government
intervention and no foreign trade. In this
case, the value of the Output Y Produced =
the value of Output sold.
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Savings = Investments
Three Sector Model of Circular Flow of
Income (Open Model)
In this model, the government is included.
The intervention of the government
Government Expenditure
Government Borrowing
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National Income Identity in a 4 Sector
In a 4-sector model, we introduce trade but
we assume that it is only the business firms
that interact with the foreign countries.
4 sector Models
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1. Y = C + I
C-Consumption Expenditure
I - Investments
What happens to produced
income which is not consumed?
It is used to increase the inventories,
which is treated as actual
investments or savings.
2. Y = C + S
Putting equations 1 and 2 together
NB: - In a simple two sector model
where there is no government
intervention or foreign trade;
Steve Ouma Oyugi
deficit. If the government expenditure
exceeds the tax collected, then there would
be a budget deficit. To finance this deficit,
the government borrows from the financial
market and this reduces private investment
hence government borrowing crowds out
private investment.
Macro Economics
The National Income Identity = Total
1. Y = C + I + G
Total income consumed, saved and taxed.
2. Y = C + S + T
Y= E (Expenditure)
3. C + I + G = C + S + T
4. G - T (Deficit/Surplus) = S - I
Equation 4 explains the government budget
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NI Identity
1. Y = C + I + G + (X - M)
Where (X - M) = Xn
2. Y = C + I + G + Xn
3. I + G + Xn = S + T
The meaning of equation 3 is that the total
private investments + government
expenditure + net export = savings + Net
Kimathi University College of Technology
Steve Ouma Oyugi
2nd Year 2nd Semester
Macro Economics
Measuring the National Income
1. Value added method
This divides the economy into
sectors such as fishing, mining,
agriculture, transport, industry,
manufacturing e.t.c. We then
calculate the net value added by
each sector at factor cost and market
price. In order to obtain the net
value, we subtract the cost of
intermediaries (raw materials used to
produce the end product, capital
depreciation) but add the net factor
income from abroad.
NB: - NI or Net National Product =
NDP (fc) + NFI. Where fc means at
factor cost.
Significance of the value added
• The method reveals the
performance of the sector.
Precautions to take when using
the value added method
• The value of self occupied houses
should be included.
• 2nd hand goods are excluded
• Production for self consumption
should be included
• Services from housewives is
normally omitted due to
complications that arise in
2. Income method
The NI is obtained by summing up
the incomes of all individuals of a
country. This constitutes rent from
Steve Ouma Oyugi
Macro Economics
Kimathi University College of Technology
land, interest on capital, wages and
salaries and profits from
3. Expenditure method
Involves adding up all the
expenditures made on goods and
services within 1 year. This
expenditure is on the consumer
goods and services by individuals
and households denoted by (C), the
government expenditure denoted as
(G), expenditure on the capital goods
and inventories denoted as (I) and
Net Export Expenditure denoted at (X
- M) where (X - M) is Xn.
GDP = C + I + G + Xn.
Difficulties in measuring
National Income
• Treatment of non-monetary
transactions e.g. housewives
services and household
• Treatment of government
activities like defense, social
services like free education and
• Activities of foreign firms and
profit repatriation. NB: - Income
from foreign firms is introduced
and treated as National Income
yet we know that it ends up back
in their countries.
• Lack of accurate record keeping
particularly by the households.
• Lack of specialization by
Limitations of GDP as a Measure
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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
• 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
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
Income and Expenditure Approach
The Keynesian is a short-term approach,
which assumes that the price level in the
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Steve Ouma Oyugi
2nd Year 2nd Semester
Macro Economics
economy remains unchanged.
Keynes also assumes that the stock of
capital, techniques of productions and labor
efficiency remain unchanged.
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
Consumption Demand
This depends on the marginal propensity to
consume and the level of National income.
Keynes assumes that investment is
autonomous and does not change with the
changing levels of income.
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Take note that C + I is parallel to C = a +
bY, indicating that the level of investment is
constant and does not depend on change in
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OZ is the income line
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:
1. Marginal efficiency of capital
(Expected Rates of Profits)
2. Rate of interest
Steve Ouma Oyugi
Kimathi University College of Technology
Macro Economics
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 technology, with labor being the
only variable factor.
Keynes Criticism of Classical
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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
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
There may also be several other reasons for
saving such as to provide for education and
contingencies, holidays and even at old age
Kimathi University College of Technology
Steve Ouma Oyugi
2nd Year 2nd Semester
Macro Economics
and retirement. Therefore savings may not
be equal to investments, this results to a
level of unemployment.
The level of investment depends upon the
marginal efficiency of Capital, which is the
main motivation for investment. i.e. if the
expected rates of profits are not favorable,
then people are not able to invest.
Keynes Analysis of a 2 Sector Model
(Keynesian Multipliers)
We assume that there isn’t government
taxation and expenditure and we are
dealing with a closed economy.
National Income
C = a + bY
I = Ia (Investment is
Y = (a + bY) + Ia
Y = a + bY + Ia
Y – bY = a + Ia
Y(1 – b) = a + Ia
Y = (a + Ia)/(1-b)
Y = [1/(1-b)]a+Ia
Savings Investment Approach
But Y = C + I;
thus I = Y – C
Yet C = a + bY
Therefore: - However, to obtain Y = (I +
then since S=I from iii
a + bY = Y – SI=Y – a - bY
Y=I + a + bY
S = Y – a – bY
= -a + Y – bY
= -a + Y(1 – b)
1 – b is the marginal propensity to save. If
the level of savings is very high then the
level of multiplier increases too.
Relevance of Keynesian Analysis in
Respect to Developing Countries
Nb: - An increase in b leads to an increase in
Equation iii shows the equilibrium level of
occurring where Aggregate Demand is equal
to aggregate supply.
The level of equilibrium Y can be obtained
by multiplying the autonomous investment
by the multiplier. The higher the marginal
propensity to consume the higher the level
of income.
Steve Ouma Oyugi
Kimathi University College of Technology
Macro Economics
Keynes put forward a theory of income and
employment, which explains the
determination of income and employment
through the aggregate demand and supply.
***Keynes, at a time of economic depression
(1930’s) in Europe, where the level of
aggregate demand was the main cause of
in developing economies, poverty and
unemployment result from lack of capital,
relative to labor availability.
Thus in developing nations, there is supply
side constraint resulting from lack of capital
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and means of production. Keynes proposed
such measures as increased government
expenditure as a remedy for Europe.
If this is applied in developing countries it is
going to be inflationary. Dr. R. V. Rao
ascertains that the Keynesian multiplier is
inapplicable in underdeveloped/developing
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.
Application of Consumption Function
Aggregate demand and supply cannot fully
explain full employment and for
employment to exist savings must equal
investments failure to which we experience
involuntary unemployment.
Marginal propensity to consume explains
the consumption changes. Consumption
changes at a lower rate than increase in
In order to maintain a certain level of
income and employment the gap between
income and consumption should be
matched by investment to prevent
It is important in understanding the
multiplier since the size of the multiplier
depends on the marginal propensity to
Entrepreneurs base their investments on
the marginal efficiency of capital, which is
determined by current levels of
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
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Steve Ouma Oyugi
2nd Year 2nd Semester
Macro Economics
An investments results to an increase in
income by the value of the multiplier.
However, income doesn’t increase
indefinitely since the marginal propensity to
consume is less than one due to the
following leakages;
Debt payment
Precautionary and speculatory motives of
cash balances
Importation – increase income in foreign
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
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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.
C is the supply price of the cost of capital
R is the annual expected yields of
r is the expected rates of return of profits.
Investment Demand
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(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
This should be differentiated from financial
investment, which involves trading in
shares, stocks and bonds, which is simply
the transfer of ownership.
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.
Autonomous Investment
Marginal efficiency of capital
Steve Ouma Oyugi
Macro Economics
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
Equilibrium level of investment is attained
where the marginal efficiency of capital is
equal to the current rates of interest.
The marginal efficiency thus represents
Economic depression is a signal of expected
marginal efficiency of capital hence low
investment demand.
Marginal efficiency of capital (shift
• Increase in demand for products
leads to change in level of
• Change in technology and efficiency
• User cost of capital (this determines
Kimathi University College of Technology
Steve Ouma Oyugi
2nd Year 2nd Semester
Macro Economics
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
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more due to change in income from Yt-1 to
This means that investment is also a
function of a change in income.
Accelerator Principle on Investments
Post Keynesian economists argue that
investments is also a function of income
since an increase in income increases
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
Steve Ouma Oyugi
Macro Economics
7th July 2010
Kimathi University College of Technology