AEF 302

PRINCIPLES OF MACROECONOMICS
LECTURERS: Prof. A. Muhammad-Lawal
Dr. S.O. Akanbi
Dr. (Mrs) T.B. Ajibade
Course outline
1. National income accounting
Problems of national income accounting
National income and welfare measure.

2. Consumption Theory
Keynesian Absolute income hypothesis
Friedman’s permanent income hypothesis
Life- cycle hypothesis

3. Investment theory
The decision to invest
Investment and interest rate
Accelerator theory of investment

4. Interest and Money

Demand for money
Theories of the demand for money
The supply of money
Monetary and fiscal policies

5. Theories of Interest
The classical theory of interest
The Keynesian theory of interest

6. General equilibrium in the product and money markets

Derivation of the IS and LM functions
Shifts in the IS and LM functions
Government and General equilibrium

7. Growth and Development

Determinants of economic growth
Barriers to growth in the developing countries

Recommended Texts
1. David Begg, Stanley Fischer and Rudiger Dornbush Economics 6th ed. The Mc Graw-Hill Companies,
2000
2. Richard T. Froyen Macroeconomics Theories and Policies 6th ed. Prentice Hall, 1999.
3. Bradley R. Schilleh, The Macroeconomy Today 7th editon, Irwin/McGraw – Hill, 1997.
4. Alfred W. Stonier and Douglas C. Hague A Text Book of Economic Theory5th ed., Pearson Education
Ltd. 2005
5. Richard G. Lipsey and K. Alec Chrystal, An Introduction To Positive Economics 8th ed. Oxford
University press, 1995.

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INTRODUCTION
Macroeconomics is the study of how the economy behaves in broad outline without dwelling on much of its detail.
Macroeconomics is largely concerned with the behaviour of economic aggregates such as total national product, total
investment, and the exports for the entire economy. It is also concerned with the average price of all goods and
services, rather than with the prices of specific products. In contrast, Microeconomics deals with the behaviour of
individual markets and with the detailed behaviour of individual agents such as firms and consumers.

In Macroeconomics, values of all goods and services are added with a view to studying the movement of the aggregate
national product. Besides, the general price level for the entire economy is discussed using the average of the prices
of all goods and services.

In Macroeconomics, we look at the broad range of opportunities and difficulties facing the economy as a whole. When
national product rises, the output of most products and the incomes of most people usually rise with it. When the price
level rises, virtually every one in the economy is forced to make adjustments because of the lower value of money.
When the unemployment rate rises, workers are put at an increased risk of losing their jobs and suffering losses in
their incomes. These movements in economic aggregates are strongly associated with the economic well being of
most individuals vis – a vis the health of the sectors in which they work and the prices of the goods that they purchase.
These associations are why macroeconomic aggregates particularly inflation, unemployment and the balance of
payments are often in the news.

NATIONAL INCOME ACCOUNTING

Economics deals with the national well being of people. People derive this material well being from the flow of goods
and services available for their uses which are produced in the country during the year. It is this flow which we can
call the national income or output, which economists are interested in increasing. Economics is therefore concerned
with the production of income in the form of goods and services with its distribution among themselves, groups or
countries with the stability of production, and with a whole range of diverse factors and influences that impinge
directly on these things.

Economists can only assess the effectiveness of economic policy by measuring/or knowing what is happening to
national income. Note that income is measured per unit of time usually one year; the flow of income includes services,
as well as goods although money value is the only common denominator which enables us to add up to make up
incomes, our concern is not with money itself but what money will buy. Thus, national income is a measure of the
money value of goods and services which arise from the productive activities of the nation in any one year.

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The Great Depression of the 1930s was an object lesson in the need for better measures of economic performance.
There were plenty of anecdotes (stories) about factories closing, farms failing, and people engaging in petty trades.
No body however knew the dimensions of the nations economic melt down until millions of workers had lost their
jobs. The need for more timely information on the state of the national economy, which became evident from that
experience, then led to a commitment to national income accounting.

National income accounting is the measurement of aggregate economic activities particularly national income and its
components. It provides a useful perspective on the way the economy works. It shows how factor markets relate to
product markets; how output relates to income; and how consumer spending and business investment relate to
production. It also shows how the flow of taxes and government spending may alter economic outcomes.

We must also take account of depreciation, the wear and tear in capital equipment used to produce output. If no steps
are taken to maintain the productive capacity of the nation’s stock of equipment, the flow of goods and services will
eventually decline.

Approaches to Income Measurement

A large array of goods and services constitutes total output of an economy. The problem however is finding a summary
measure of the goods and services. To facilitate our accounting chores, we need some mechanism for organizing
annual output data into a manageable summary. The mechanism in use is prices. Each good and service produced and
brought to the market has a price. That price serves as a measure of value for calculating total output. Once we know
the price of each good, we can calculate the value of output produced in a given time period. The total monetary value
of final output produced each year within a country is referred to as Gross Domestic Product (GDP). GDP can
therefore be simply described as the sum of all final goods and services produced within a country for the market in a
given time period, with each good or service valued at its market price. The use of prices to value market output allows
us to summarize output activity and to compare the output of one period with that of another.

We can have three approaches to measurement of national income. Each time something is produced and sold, we can
say:
i. Its value is equal to consumers’ expenditure on it
ii. The same amount will be received as income by the various people who contributed to it production.
iii. The same value will have come about as a result of the “value added” to their products by successive
stages of production.
If therefore, we wish to calculate the total money value of goods and services produced and sold during the year, in
theory, we can do it in any one of three ways:
1. We can add up market expenditure by final consumers including purchases of goods by firms (Expenditure
approach).
2. We can add up the income received by the different individuals (Income approach).
3. We can find out the value of each firm’s contribution to output and add the “value added” alternatively
described as the “net output / product”

The product (output) method, income method and expenditure method are three ways of deriving the same total. We
can therefore say that national product (output), national income and national expenditure are necessarily equal in that
they refer to the same total

The Income Approach

Each time a product is produced and sold, some one obtains income from producing it. More precisely, each unit of
expenditure will find its way partly into wages and salaries, profits, interest or dividends or rents. In other words, one
person’s expenditure always represents another person’s income. That is money spent on goods and services provides
income to someone. It may go to a worker (as wage or salary) or to a business firm (as profit and depreciation
allowance). It may go to a land lord (as rent), to a lender (as interest) or to government (as sales or property tax).
It follows that if we add up all incomes we should get the value of total expenditure, or output. In calculating the value
of output, we must only count incomes received by providing output. The test for inclusion in the national income
calculation is therefore that there should be a “Quid pro quo”, that is, that the money should have been paid against
the exchange of a good or service. If there is no “quid pro quo” it is a transfer payment and should not be included.

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The Expenditure Approach
The total value of goods and services produced during a period of time may be obtained by adding up all expenditures
on goods and services during the year. Expenditure approach examines the components of final demand which
generate production. This includes the four set of market participants namely consumers, business firms, government
and foreigners. Those goods and services used by households are called consumption goods. Investment goods
represent another use of GDP. These are plant and machinery and equipment produced. Net changes in business
inventories and expenditures for residential construction are also counted as investment. The third major user of GDP
is the public sector. Federal, state and local governments purchase resources to police streets, build highways, schools
etc. Finally, we should note that some of the goods and services we produce each year are used abroad. That is to say,
we expect some of our output to other countries. Since goods and services are also imported the value of all imports
are simply subtracted. The difference between the two expenditure flows is called net exports.

What we end up with is a simple method for computing GDP. The value of GDP can be computed by adding up
expenditures of market participants.

Specifically, GDP = C+ I + G + (X – IM)

Where C = Consumption expenditure
I = Investment expenditure
G = Government expenditure
X = Exports
IM = Imports

This can also be represented by the following:

E=C+I+G+X
The right hand side implying that nationals may receive their incomes by sale of consumer goods (consumption), by
sale of capital goods (investment) by the sale of goods to government (government expenditure) and by the sale of
goods to overseas buyer (exports).

In measuring consumption and investment expenditure, we must stress that it is only what we may term finally
expenditure which must be counted. Investment has two main components: fixed investment, which means addition
to the stock of durable producer goods, such as machines and inventory investment, which means addition to stocks
of goods, which have been produced but not sold to final buyers during the period. The latter includes work in progress,
that is, additions to stock of unfinished goods.

The letter G refers to general government expenditure on current goods and services, that is, expenditure on the
provision of goods and services for consumption by all public authorities at every level. Investment expenditure on
capital goods such as roads and building are usually included under “I”. Goods and services provided by public trading
enterprises are also excluded from “G” being part of private expenditure, as are purchases from private producers, and
also factor services from households. These factor services comprise, in the main, the “wage bill” for civil servants,
teachers etc. who contribute to the nation’s “product” and “Income”.

Government transfer payments including interest on public debt and subsidies are however excluded, because they
have already increased disposal private income available for private expenditure “C” (and in part, “I”).

If a commodity though largely produced at home includes some foreign raw materials, the values of these must be
removed. C,I, and G in other word must be given free of any import content. Alternatively, we can leave in this, import
content and subtract imports in one lump, calculating
Y = C + I + G + X – M.
Where M is the value of imports. Y is the GDP.

Two final problems remain if we are to obtain the same total by the expenditure approach as we did using the income
approach. The first also relate to international transactions. Under the income approach, we included all income
received from property such as rents, interests and dividends. Some of these, however, will have been received by
people who are not residents in the country. If we want a figure for national expenditure corresponding to national

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Income, that is income accruing to nationals of the country, we must subtract this figure. On the other hand, residents
of the home country will also have received property income on investments in other countries and this must be added.
We therefore have in full: Y = C + I + G + X – M + P; Y = GNP

Or Gross National Product = total domestic expenditure (C + I +G), plus the net external trade ( X- M), plus net
property income received from abroad, P. In addition to net receipts or payments on account of international capital
movements some countries are importers or exporters of labour services which must be added to domestic income in
calculating national income. Thus the letter P may be used to include all kinds of net factors income received from
abroad.

The second complication is associated is associated with indirect taxes and subsidies. The total of incomes obtained
under the income approach represented payments to factors of production for goods and services supplied payments
“in exchange for national output”. But people’s expenditure on a commodity need not all goes to suppliers. If we add
expenditures together we shall obtain expenditure at market prices which differ from payments to factors by the
amount of indirect taxes. In the event that goods are sold below the full cost of production a subsidy is being provided
which must be added to the market price to measure product and expenditure at factor cost.

National expenditure at market prices minus indirect taxes plus subsidies minus indirect taxes plus subsidies = national
income at factor cost.

The Product (Net output/ value added) Approach

The most direct method of calculating the value of national output is, of course, to add the values of the combinations
of all the individual enterprises in the economy. We must remember to count only the value added by each firm;
subtracting from the gross value of production the cost of the raw materials which the firm has not itself produced.
Value added is therefore total revenue less what has been paid to other firms for commodities supplied or services
rendered. This must include output which is exported and the output of government. It must be noted that in order to
get national output at factor cost we must use the total revenue of firms excluding indirect taxes and subsidies.

Finally, the sum of outputs produced in the home country will not include net property income from abroad, which
should be added to get national income at factor cost.

National income or product can be defined as the income received by normal residents of the country from productive
activity. This tells us that we must include income from productive activity even if it is earned abroad, if it accrues to
residents and we exclude income earned in the domestic economy if it accrues to non residents.

We use the term domestic income or product to refer to all earnings made within the domestic economy irrespective
of whether they accrue to residents or non residents. This will exclude net factor income earned abroad.

Domestic and national income can be expressed gross or net, at factor cost or at market prices. Gross national product
at factor cost is usually referred to as the GNP so that we have
GNP (fc) + net indirect taxes = Gross national product at market prices.
GNP (fc) - net factor income from abroad = GDP at factor cost
Note that GDP (fc) = GDP at market price - net indirect business taxes
GNP (fc) – depreciation = Net National Product at factor cost. This can be considered as the national Income.

Alternatively, National Income can be calculated as follows:

National Income = GDP(mp) + net factor income from abroad – indirect business taxes – depreciation

Net Domestic Product

Changes in real GDP from one year to another tell us how much the economy’s output is growing. Some of that
growth, however, may come at the expense of future output. Recall that production possibilities determine how much
output an economy can produce. If an economy uses some resources to produce this year’s output, future production
possibilities may shrink. Next year, the economy may not be able to produce as much output unless factors of
production used this year are replaced. Purchase of final goods and services create a flow of income to producers and
through them, to factors of production. But a major diversion of sales revenue occurs immediately as a result of

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depreciation charges made by a business. Note that capital resources are used up in the process of production. For
most part, these resources are owed by business firms that expect to be compensated for such investments.
Accordingly, they regard some of the sales revenue generated as reimbursement for wear and tear on capital plant and
equipment. They therefore subtract depreciation charges from the gross revenues in calculating their incomes.
Depreciation charges reduce GDP to the level of Net Domestic Product (NDP) before any income is available to
current factors of production. By subtracting depreciation from GDP we get net domestic product (NDP). This is the
amount of output we could consume without reducing our stock of capital and therewith next year’s production
possibilities. Therefore NDP = GDP – Depreciation.

The distinction between GDP and NDP has direct implications for the mix of output. To maintain its production
possibilities, an economy must at least replace the capital consumed. This means that at least some of each year’s
output will have to consist of newly produced plant and equipment ie. investment goods. Indeed, gross investment
must at least match the depreciation or else, stock of capital and production possibilities will shrink.

Depreciation
Plant and equipment (Capital) are routinely used in the production process. To maintain the production possibilities
therefore, we have to at least replace what we have used. The value of capital used up in producing goods and services
is commonly called Depreciation or Capital Consumption Allowance. In principle, it is the amount of capital worn
out by use in a year or made obsolete by advancing technology.

Indirect Business Taxes

Another major diversion to the income flow is the indirect business tax. When goods are sold, their purchase price is
typically filled up with some sort off sales tax. Thus, some of the revenues generated in the product markets disappear
before any factor of production get a chance to claim it. These IBT as they are called, are not considered part of
national income because they do not represent payment to factors of production. They however account for a large
part of the income spent in the market places. Once depreciation charges and the indirect business taxes are subtracted
from GDP, we are left with national income which is the total income earned by factors of production.

Thus, National Income (NI) = NDP – IBT + net factor income from abroad

GDP vs. GNP

Gross national product (GNP) refers to the output produced by a country’s owned factors of production regardless of
where they are located. Gross Domestic Product on the other hands refers to output produced within a nation’s borders.

Measuring price changes – Real vs. Nominal GDP

Although price serves as a convenient measure of market value, they can also distort out perceptions of real output.
Imagine what happen to our calculations of GDP if all prices were to double from one year to another. Obviously, the
price increases would double the value of final output. Such a rise in GDP does not reflect on increase in the quantity
of goods and services available. Hence, changes in GDP brought about by changes in the price level can give us a
distorted view of economic activity.

To distinguish increases in the quantity of goods and services from increases in their prices, we must construct a
measure of GDP that takes into account price level changes. We do so by distinguishing between real GDP and
nominal GDP. Nominal GDP is the value of final output measured in current prices, whereas real GDP is the value of
output measured in constant prices. To calculate real GDP, we adjust the market value of goods and services for
changing prices.
The general formula for computing real GDP is as follows:
Real GDP in year t = Nominal GDP in year t * Price level in base year/ Price level in year t
For convenience, the price level in the base year is often set at 100.

Personal Income
National income is the income earned not only by households (consumers) but also by corporations. Theoretically, all
the income received by corporations represents income for their owners i.e. the households who hold stock in the

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corporations. But the flow of income through corporations to stock holders is far from complete. First, corporations
must pay taxes on their profits. Accordingly, some of the income received on behalf of the corporations’ share holders
goes into the public treasury rather than into private bank accounts.

Second, corporate managers typically find some urgent need for cash. As a result, part of the profits are retained by
the corporations rather than passed on to the stockholders in the form of dividends. Accordingly, both corporate taxes
and retained earnings must be subtracted from national income before one can determine how much income flows
into the hands of consumers.

Still, another deduction must be made for social security taxes. Nearly all people who earn a wage or salary are
required by law to pay social security “contributions”. Workers never see this income because it is withheld by
employers. Thus the flow of national income is reduced considerably before it becomes personal income, the amount
of income received by households before payment of personal taxes.

Not all our adjustments to national income are negative. Households receive income in the form of transfer payments
from the public treasury. These income transfers represent income for the people who receive them. People also
receive interest payments in excess of those they pay (largely because of interest payments on the government debt).
This net interest is another source of personal income. Accordingly, our calculation of Personal Income is as carried
out as follows:
National Income ( income earned by factors of production )
Less Corporate taxes
Retained earnings
Social security taxes
Plus Transfer payments
Net interest
Equals Personal Income (Income received by households)

Disposable Income
The total flow of income generated in production is significantly reduced before it gets into the hands of individual
households. Personal income taxes are withheld by the employer, who thus acts as a tax collector. Accordingly, to
calculate Disposable Income which is the amount of income consumers may themselves spend (dispose of). Therefore
Disposable income = Personal income
less Personal taxes.

Disposable income is the end of the accounting line. Once consumers get this Disposable Income in their hands, they
face two choices. They may choose to spend their Disposable Income on consumer goods and services or save it.
Saving in this context simply refers to Disposable Income that is not spent on consumption. Thus all Disposable
Income is, by definition, either consumed or saved – i.e.
Disposable Income = Consumption + Saving

GDP per capita: The Standard of living

International comparisons of total output are usually more vivid in per capita terms. GDP per capita relates the total
value of annual output to the number of people who share that output. It refers to the average GDP per person. GDP
per capita is commonly used as a measure of a country’s standard of living. Per capita GDP is only a statistical
phenomenon, however, and should not be interpreted as a measure of what every citizen is getting. Measures of per
capita GDP tell us nothing about the way GDP is actually distributed or used; they are only a statistical average. When
countries are quite similar in structure, institutions, and income distribution, however or when historical comparisons
are made within a country, per capita GDP can be viewed as a rough – and – ready measure of relative standard of
living.

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Let us consider how our national income statistics are related to people’s material well – being or standard of living
or economic welfare of the inhabitants of the country which is the aim of production and which measures the
effectiveness of the country’s productive system.
Since standard of living is an extremely difficult concept to specify, the most obvious measure however is real income
per head, total “real” income divided by the number in the population. This tells us the value of good and services
received during the year by the average man.

Three kinds of problems arise in using real income per head to measure the standard of living in different countries.
The first kind is conceptual: is this the appropriate measure or is an alternative measure preferable?
The second kind is statistical: can we obtain accurate and comparable figures of income per head in different countries?
The third are the problems of interpreting the result: What exactly is the relation between our statistical measure and
the reality of how well off people feel.

Conceptual
1. It may be argued that real consumption per head is a more appropriate measure of well being, since it relates
to the goods and services actually consumed. This would leave out the capital goods produced during the
same period. Capital goods however create incomes which affect the level of consumption.
2. We should really assess goods and services produced in relation to human efforts that have gone into
producing them. If people work harder they will get more goods but they may prefer the extra leisure.

Statistical Problem
1. Africa do not generally have very accurate population figures to find the ratio
2. Problem relating to the numerator of the ratio. We must ensure of course that the same concept and definition
of national income is used for all countries being compared. E.g. gross or net income, domestic or national
income, income at factor cost or market prices.
3. In comparing two countries, same currency must be used in the valuation of the goods and services produced
in economies during a period. These values (currency) may not be the same in terms of goods and services
they can buy in their respective countries. This is because the domestic price levels may be more expensive
in one country than another.

Interpretation of results
1. It must be remembered that real income per head is only an index of economic welfare or material well being
which have direct relationship; we can not however say by how much it has increased and certainly not that
it has increased in proportion. In other words, we can not measure material well being on an arithmetic scale
the way we can measure real income per head. The point is that at low levels of income, the more basic needs
are satisfied, particularly food and shelter.
2. A crucial factor to bear in mind also is the distribution of income. Comparisons of average incomes mean
little if there is a widespread of incomes.
3. Another difficulty is that tastes are not the same for all countries. The point is that people in some countries
may prefer for instance food which is cheaper. The fact that you do not have access to some costly materials
does not mean lack of welfare.
4. Needs may also be very different in different parts of the world. Climatic conditions for example may produce
the need for more substantial houses and production of warm clothing these will then be reflected in the
structure of production and in national income. Such differences between countries are really costs which do
need to be incurred in the warm countries.
5. Price structures which are different in different countries make comparisons difficult. In poor countries
domestic servants are usually extremely cheap while it is expensive in advanced countries. Conversely,
domestic appliances like washing machines are cheap there. Differences in relative prices of different kinds
of goods, due to differences in their availability, mean that people can increase their welfare if they are willing
to alter their consumption in the direction of the cheaper goods.
The problems referred to obviously become more acute when trying to compare the economic welfare of two countries
than when assessing the improvement over time in the situation in any one country where the costs like heating and
transportation will be constant as well as price structures and the social, historical and cultural basis of the society will
change only slowly and of course the statistical coverage will be more uniform.

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Problems of National Income Accounting
Non market activities – Although the methods for calculating GDP and per capita GDP are straight forward they do
create a few problems. For one thing, GDP measures exclude most goods and services that are produced but not sold
in the market.
Unreported Income – the GDP statistics also fail to capture market activities that are not reported to tax or census
authorities. Many people work “off the books” getting paid in reported cash. This “underground economy” is
motivated by tax avoidance and the need to conceal illegal activities. Although illegal activities capture most of the
headlines, tax evasion on income earned in other wise legal pursuits account for most of the underground economy.