You may have already studied microeconomics, which
looks at supply, demand and prices for individual
goods. Macroeconomics looks at the bigger picture
and involves the study of the economy as a whole.
Let us start by looking at a simple example - a
'two sector' economy made up of households
(consumers) and firms (producers) -and use this to
develop the idea of national income. To start with
we will ignore the impact of government policy and
Households ultimately own the factors of
production, e.g., labour, materials and capital,
and supply these factors to firms who use them to
produce goods and services. In return households
earn rewards for supplying the firms with the
factors of production e.g., wages and interest on
capital. These rewards are in turn used to buy the
goods that the firms have produced. This process
is known as a circular flow- see Figure 1.
Figure 1: Simple circular flow
From Figure 1 we can see that there are three ways
of measuring the amount of economic activity in
the economy. These are:
(a)National product/output = the flow counted at
this point represents the amount received by firms
for their total production.
(b) National income = the flow counted at this
point represents the total income received in
return for factors of production.
(c) National expenditure = the flow counted at
this point represents the total expenditure by
households on goods and services.
If it is assumed that all income is spent, then
whichever method is used the same measure of
economic activity must be obtained. Let's look at
a numerical illustration.
Assume there are two producers - a lumberjack and
a carpenter. The carpenter makes chairs each of
which needs £5 worth of wood and which he sells
for £20. Total annual sales are 10,000 chairs. The
income and expenditure accounts for the lumberjack
and carpenter are:
'National Product' = 200
This is the total value of the production (i.e.,
'National Income' = 40 + 20 + 50 + 40 + 10 + 5 +
20 + 15 = 200
This is the total received for factors of
production i.e., wages, interest, rent and profit
'National Expenditure' = 200
This is the total amount spent on production (i.e.
We can see that the three measures of economic
activity all give the same value.
Now we can start adding to this model to make it
more realistic. This model will use the following
Consumption (C) - consumption goods produced and
sold to customers i.e., the chairs.
Savings (S) - income that is not spent on
Investment (I) - production of, or expenditure
on, non-consumption goods (carried out by firms)
including expenditure on increasing stocks of
Injections - expenditure on domestic output not
originating from consumers...