Introduction to Macroeconomics Notes

H2 Economics Chapter 5 and 6 Notes This document is intended as a summary of the points provided in the NJC 2024 H2 Economics Chapter 5 and Chapter 6 Seminar Notes. It is to be used as a study guide to provide a structure for studying the Chapter 5 and Chapter 6 Notes. 1 The Circular Flow of Income The Four Sector Economy is a model of a country’s domestic economy. It is the basis of all Macroeconomics. It consists of four sectors, and one intermediary, each of which play a very important role in the economy: Households buy goods and services as they want to maximise their satisfaction. They also provide resources like labour, land, capital and entrepreneurship to firms. Firms produce goods and services using resources provided by households, and sell them as they want to maximise their profits. The Government taxes households and hires firms to produce public goods and services as they want to maximise societal welfare. The Foreign Sector trades with the domestic economy by buying exports and selling imports. The Bank collects savings from households and funds investments by firms. In the Four Sector Economy, it is important to understand that there is a movement of money between sectors ( money flow ) and a movement of goods and services between sectors ( real flow ). This is explained using Eli’s Story of Macroeconomics. Eli’s Story of Macroeconomics (4-Sector Economy) In 2024, country X’s economy functions as it always has. firms produce goods and services and sell them in order to maximise their profits. In order to do so, they make factor payments to households to hire resources. Afterwards, households receive this money as factor income. Using a large part of the income households have received, they spend on goods and services produced by firms in order to maximise their satisfaction. The goods and services purchased may be domestically produced or imported from the foreign sector. The remaining income that households have is either saved in the bank or paid to the government as taxes (Households do receive subsidies from the government, but generally, they are taxed more than they are subsidised). 1

NJC H2 Economics 2024 Chapter 5/Chapter 6 The bank uses most of the savings of households to fund firms’ investments in productive assets (machinery, which, when built, can produce goods and services in the future). The government uses most of the taxes it collects mainly to hire firms to produce public goods and services. The foreign sector uses most of the revenue they receive from domestic households purchasing imports to purchase exports from domestic firms. Firms, using funds from the bank and the government, as well as export revenue from the foreign sector, again make factor payments to households to hire resources to produce goods and services. And again, households receive factor incomes and spend it, save it and pay taxes. The story’s message is that eventually, whatever income is received by households is either spent by households (Consumption Expenditure), firms (Investment Expenditure), the government (Government Expenditure), or the foreign sector (Export Revenue 1 ). Or, more simply, National Income = National Expenditure The diagram below illustrates this concept as it shows that factor payments, which is national income, eventually end up as national expenditure (C d + I + G + X). 1 We say ‘export revenue’ and not ‘export expenditure’ because Macroeconomics is studied from the perspective of the domestic economy. The domestic economy receives money which is spent by the foreign sector as revenue . 2

NJC H2 Economics 2024 Chapter 5/Chapter 6 Injections (J) are additions of spending to the circular flow of income. The three injections are Investment Expenditure (I), Government Expenditure (G) and Export Revenue (X). Withdrawals (W) are subtractions of spending from the circular flow of income. The three withdrawals are Savings (S), Net Taxes (T) and Import Expenditure (M). This idea is usually extended to include the idea of National Output: the total value of all goods and services produced domestically. Since the value of the goods and services is determined by the amount of money spent on them, we can make a final conclusion: National Income = National Expenditure = National Output A Key Distinction: In the calculation of national output, we use the formula Y = C + I + G + (X - M). Notice that we are taking away the value of imports. This is due to the definition of national output specifying that we are only taking into account the value of goods and services produced domestically. It must be noted that C ≠ C d . C refers to consumption expenditure, which is the expenditure on goods and services which are domestically produced and foreign produced. C d refers to domestic consumption expenditure, which is the expenditure on only domestically produced goods and services. Hence, C = C d + M. Since we have specified that we are only going to look at goods and services produced domestically, we are only interested in C d . The value of domestic goods and services bought by consumers is C d . The value of domestic goods and services bought by firms is I. The value of domestic goods and services bought by the government is G. The value of domestic goods and services bought by the foreign sector is X. As a result, we can say that Y = C d + I + G + X. C d = C - M, so we can say that Y = C + I + G + (X - M) 3

NJC H2 Economics 2024 Chapter 5/Chapter 6 2 National Income National Income refers to the income generated from the production of all final goods and services by a country within a specific period, normally a year. There are two main ways in which we may calculate the national income of an economy, namely Gross Domestic Product (GDP) and Gross National Income (GNI). Gross Domestic Product (GDP) is the total monetary value of all final goods and services produced within the geographical boundaries of a country, (regardless of the ownership of the factors of production, within a specific period, normally a year), before accounting for depreciation. Each word in the phrase ‘GDP’ has a meaning which is incorporated into the definition of GDP. ● Gross is an adjective meaning “total; without deductions for expenses or taxes” ● Domestic is an adjective meaning “within the geographical boundaries of a country” ● Product is a noun meaning “the value associated with goods and services produced” ● Nominal is an adjective meaning “measured at current prices; before acco