BE 4023

Principles of Macroeconomics
CHAPTER 1: INTRODUCTION TO MACROECONOMICS
1.1 Meaning of Macroeconomics

• The study of large economic units, such as that of the overall economy
of a country.

• The study of economic aggregates.

• National Output, National Income, General Price Level, etc.

1.2 Distinction between Microeconomics and
Macroeconomics
◦ Output.
Output of a single firm (microeconomics) vs National Output
(macroeconomics).

◦ Price.
Price of a single product (microeconomics) vs General Price Level
(macroeconomics)

◦ Employment .
Employment in an individual economic sector (microeconomics) vs Overall
employment in a country (macroeconomics).
1.3 Main Macroeconomic Concepts
◦ Stock and Flow.
◦ Circular flow (model of an economy).
◦ Fundamental macroeconomic identity .
◦ Gross Domestic Product (GDP) and economic growth.
◦ Labour force, employment and unemployment.
◦ General price level and inflation.
◦ Money Supply
◦ Interest rates and Exchange rates.
◦ Balance of (international) payments and International Reserves of Bank Negara Malaysia (BNM).
◦ Government Budget (Balance) and Government Debt
◦ Refer Economic and Monetary Review 2021 (BNM) p 24-25 for the latest key economic statistics of
Malaysia
Circular flow of income model in a closed economy with no
government
The circular flow of income model (Closed
Economy)
◦ The circular flow of income model shows the flow of income and expenditure
between the different sectors in the economy.

◦ Households provide factor inputs which include labour, land, capital and
entrepreneurship to firms and in return, they receive factor income in the
form of wages, rent, interest and profits.

◦ Firms provide goods and services to households and in return, they receive
payments known as consumption expenditure.
Fundamental Macroeconomic Identity
◦ National Output Ξ National Income Ξ National Expenditure

◦ Alternative identical measures of the level of total economic activity in a

country, over a period of time, usually a year (quoted in terms of money).

◦ The size of the economy of a country is popularly measured by the country’s

National Output.
Gross Domestic Product (GDP) and economic
growth
◦ GDP is the most popular measure of National Output.

◦ Economic growth () is the increase in the productive capacity of a country

over time.

◦ rate is popularly measured as the percentage increase in GDP over time (year
to year or quarter to quarter)
Labour force, Employment and Unemployment
◦ Labour force = Employment + Unemployment

◦ Unemployment rate is the proportion (or percentage) of the

labour force that is unemployed
General Price Level and Inflation
◦ General price level is the average of the prices of the goods and
services produced in a country.
◦ The most popular measure of the general price level is the
Consumer Price Index (CPI).
◦ Inflation is defined as a continuous increase in the general price
level over time (year to year, or month to month).
◦ Inflation rate is measured as the percentage increase in the
general price level over time (year to year, or month to month).
Money Supply
◦ Money supply is the total amount of money that exists in a country
at any one point of time.

◦ Money Supply = Currency in Circulation

◦ +
◦ Demand Deposits held by the non-bank private sector
Interest rates and Exchange rates
◦ Interest rate is the rental price of money (or alternatively, price of loan), and is quoted in
percent per annum (unless specified otherwise).

◦ Many interest rates ( such as bank deposit rate, bank lending rate, etc).
◦ Exchange rate is the rate at which one currency can be exchanged for another.
◦ Price (or value) of one currency in terms of another.

◦ Given USD 1 = RM 4.5, then RM4.5 is the RM price of (one) USD.

◦ Conversely, USD 0.22 = RM 1 or alternatively, RM 1= USD 0.22,

hence USD 0.22 is the USD price of (one) RM.

◦ Many exchange rates.

Balance of (international) payments (BOP) and International
Reserves of central bank (Bank Negara Malaysia).

BOP is the record of all international transactions done by the residents of a

country with the residents of other countries during a period of time, usually a
year.
If total money inflow (outflow) is greater than total money outflow (inflow), then
BOP surplus (deficit).
If both flows are equal, then BOP equilibrium.
International reserves of the central bank of a country is the foreign currency
holdings of the central bank of the country.
BOP surplus (deficit) will increase (decrease) the international reserves.
BOP equilibrium will not affect the international reserves.
 Government Budget (Balance) and Government Debt

Government Budget is a record of the Government’s Revenue and Government’s Expenditure,

over a period of time, usually a year.
If Revenue (Expenditure) exceeds Expenditure (Revenue), then Budget has a surplus (deficit).
If both Revenue and Expenditure are equal, then Budget is said to be balanced.
Usually a deficit budget implies borrowing, and hence Govt Debt will increase, while a surplus
budget implies settlement (of debt), and hence Govt Debt will decrease.
 KEY MACROECONOMIC OBJECTIVES

Key Macroeconomic Objectives

To achieve full employment

To achieve price stability

To achieve economic growth

To achieve an equitable distribution of income

To achieve equilibrium in the balance of payments

 KEY MACROECONOMIC OBJECTIVES
(cont.)

(1) To Achieve Full Employment

Full employment does not mean there is no unemployed or
jobless people in the economy.
It does not mean 100% of the labour force is employed. It
means high employment (or, low unemployment).
The potential benefits of full employment in an economy are
that it can optimize the available resources efficiently.
The crucial consequences of unemployment to the economy
are wastage of available resources and social problems.
 KEY MACROECONOMIC OBJECTIVES
(cont.)

(2) To Achieve Price Stability

A high degree of inflation rate that is associated with a
sustained increase in the general price level can be
disastrous to an economy.
To the consumers, inflation directly influences their
purchasing power. The quantity of goods and services
purchased will be less if inflation is high.
Maintaining price stability (low and stable inflation) is
beneficial because it means uncertainty and disruptions in
the economy are avoided. It means consumers and
businesses can safely pursue long-term consumption and
production plans.
 KEY MACROECONOMIC OBJECTIVES
(cont.)

(3) To Achieve Economic Growth

Economic growth can be described as expansion in national
output over a given period of time.
As long as a nation achieves economic growth it tells us that
the economic performance is positive.
However, an economy will not always encounter an upward
trend over time as economies tend to experience short-term
ups and downs in their performance. This is called a business
cycle.
KEY MACROECONOMIC OBJECTIVES
(cont.)
 KEY MACROECONOMIC OBJECTIVES
(cont.)

(4) To Achieve an Equitable Distribution of Income

 It is necessary to ensure that the economic growth of a
nation is shared equally among the population
 Generally, policymakers try to ensure that there is no wide
gap between the rich and the poor.
 This is to ensure that all people are equal in terms of
standard of living.
 Disparities of income will create social friction and bring
out many problems.
 KEY MACROECONOMIC OBJECTIVES
(cont.)

(5) To Achieve Equilibrium in the Balance of Payments

 Long Run

 Total money inflow = Total money outflow

 International Reserves of central bank (Bank Negara

Malaysia) remain constant
1.1 The circular flow of income model (Closed
Economy)
Definition of Closed Economy

• A closed economy is self-sufficient, meaning that no imports are

brought in and no exports are sent out, in the real world means no
trade relations with any other country.

• A closed economy in which no activity is conducted with outside

economies.
• The goal is to provide consumers with everything that
they need from within the economy's borders.

• The most closed economy today is probably North Korea,

but since relies heavily on external aid to feed its people,
it cannot be described as a 'functioning' closed economy
The circular flow of income model (Closed
Economy)
◦ The circular flow of income model shows the flow of income and expenditure
between the different sectors in the economy.

◦ Households provide factor inputs which include labour, land, capital and
entrepreneurship to firms and in return, they receive factor income in the
form of wages, rent, interest and profits.

◦ Firms provide goods and services to households and in return, they receive
payments known as consumption expenditure.
Resources/ Factor of production
I. Land
◦ Land is not created by mankind but it is a gift of nature.

◦ It is also called as natural factor of production or primary factor of

production.

◦ Natural resources used in the creation of products, paid in

economic rent.
II. Labour
◦ Labour is the human input into the production process.

◦ Human capital refers to the quality of labor resources, which can

be improved through investments in education, training, and
health

◦ Human efforts provided in the creation of products, paid in wage.

III. Capital
◦ Capital includes machinery, factories, equipment, new technology,
factories, buildings and computers.

◦ Human-made goods used in the production of other goods, paid in

interest.

**Please take note: money by itself is not a factor of production.

Money becomes capital only when it is used to purchase real capital
goods like plant, machinery,
iv. Entrepreneurship

◦ Entrepreneurs are people who organize other productive

resources to make goods and services.

◦ An entrepreneur brings together land, labour and capital to

produce goods and services and is paid in profit.
The circular flow of income model (Open
Economy)
Real Flow
◦ Land/labour/capital (FOP) from households to firms corresponding to the
output (G&S) going from firms to households.

Monetary Flow
◦ Households are rewarded with wages, rent, interest and profits (Income, Y)
from firms.
◦ Firms are on the receiving end of the households’ expenditure (E).
The Circular-Flow Diagram
Factor
Markets

en r
ym to
ts
pa Fac
Labour, capital &

$
$

In
Labour, capital &

co
natural resources

m
natural resources

e
Govt.

Taxes Taxes
Import
Expenditures & Expenditures &
expenditures
Transfer payments Transfer payments

Import
expenditures Import
Foreign expenditures
Firms Export Households
countries
earnings

Interest Savings
Interest & dividends

Loans

itu on
Goods & services
$ S eip

Financial

nd pti
re

Goods & services

re
ale ts

pe um
c

institutions
s

ex ons
$C
Markets for
Goods &
Services

31
The circular flow of income model
(Open Economy)
Open Economy: Adding Financial Institutions, Government and Foreign
Countries
I. The Government
◦ Leakage: taxation (T) on households and firms
◦ Injection: government expenditures (G) on goods and services from firms and
households
◦ Transfer payments: usually in the form of subsidies to households and firms
◦ (Transfer payments are payments made by the government to the recipients not in
exchange for any goods or services and they include social security benefits,
unemployment benefits and interest payments on national debt.)
◦ Leakage: imports (M) of goods and services (military expenses) from foreign countries.
II. The Financial Institutions
◦ Leakage: households saving (S) in financial Institutions
◦ Injection: households receive interest on their savings
◦ Injection: firms borrow money from institutions and inject it back
into the system in the form of investments (I)
◦ Leakage: firms pay interest to financial institutions
III. The Foreign Countries
◦ Leakage: Households import goods and services from foreign
countries
◦ Leakage: firms import goods and services from foreign countries
◦ Injection: firms export (X) goods and services to foreign countries.
◦ Leakage: government imports of goods and services from foreign
countries.
Leakages and Injections from the Circular
Flow
I. Leakages (in terms of flow of payment)
◦ Money paid to the households but not returned to firm
◦ Flow of payments that started from firms but did not
return back to households
◦ e.g. household savings, net taxes and imports
II. Injections (in terms of flow of payment)
◦ Revenue for firms not from sales to household
◦ e.g. investment by firms, government purchases and
exports
Summarizing:
1. Leakages from circular flow of income (saving, taxes, and
imports) have the opposite effect of injections into the
circular flow of income (investments, government
spending and exports); though need not be equal to each
other.
2. If leakages are larger than injections, the income flow
becomes smaller.
◦ This means that a portion of the households’ income that leaks in
the form of saving in to financial markets does not come back into
flow as investment.
◦ For example, saving larger than investment.
3. If Injections are larger than leakages the income flow
becomes larger.
◦ Households(other countries) demand more goods and
services, firms(domestic) will begin to produce more by
purchasing more factors of production, unemployment
will fall, household income will increase
◦ For example, exports larger than imports.
Measuring National Income
National income is used to refer to Gross Domestic Product or Gross National
Product at market price.

Gross Domestic Product is the market value of all the final goods and services
produced in the economy over a period of time.

From the circular flow of income and expenditure, one can see that there are three
approaches of measuring national output
I. The income approach
II. The output approach
III. The expenditure approach
I. The income approach
Adding the factor incomes (i.e. wages, rent, interest and profits)
received by households from firms for the provision of factor inputs.

GDP = Employee compensation/wages

+ interest(profits)+ rent
+ profits(self-employed/ private
corp./ public corp
◦ Income from employment (wages and salaries)
◦ Gross trading profits of companies
◦ Income from self-employment
◦ Gross trading surplus of public corporation and general government
enterprise
◦ Rents
II. The output approach
Adding the market values of all the final goods and services produced in the
economy

However, the output of some firms is the factor inputs of others.

To avoid the danger of double counting only the money values of final goods
and services sold to consumers must be totaled or alternatively the value added
at each stage of production is added.
Value-added is the increase in the market value of a good that takes place at each stage of the
production-distribution process.

Value added = Value of output

–Value of factor inputs
Example:
Stage Industry Output Value of Value of factor Value added
output inputs
1 Farming Wheat $1000 $0
2 Milling Flour $1300 $1000
3 Baking Bread $2000 $1300
4 Retailing Selling Bread $2500 $2000

Sum of values
added
Stage Industry Output Value of Value of factor Value added
output inputs
1 Farming Wheat $1000 $0 $1000
2 Milling Flour $1300 $1000 $300
3 Baking Bread $2000 $1300 $700
4 Retailing Selling Bread $2500 $2000 $500

Sum of values $2500

added
III. The expenditure approach
◦ National expenditure is the total amount spent on consumer goods and services and on net additions
to capital goods and stocks in the course of the year.

◦ Thus, we can get national income summing up all the consumption expenditure and investment
expenditure made by all individuals as well as the government of a country.

◦ In an open economy, this involves adding consumption expenditure, investment expenditure,

government expenditure and net exports.
GDP = C + I + G + ( X – M )
= C + I + G + (NX)
Consumption (C)
Personal consumption expenditure
Household spending for newly-produced goods and services is defined as consumption.
Spending on consumer durables (car and laptop), non-durables (food and medicines) and
services (entertainment, education and banking).
Investment (I)
All spending by business firms for newly built equipment and business structures.
All changes in business inventories of raw materials, semi-finished goods, and finished goods
(stocks).
All spending by households for newly constructed residential housing
** Remember that investment only happens when there is production of new tangible capital
goods for the year

Investment does NOT include

◦ The purchase of stocks, bonds, or other financial assets.
◦ Secondhand sales
Government Spending (G)
All spending on goods and services by government at all levels within a country.
Includes purchases by government of factors of production, including labour services (hire
teachers, build roads).
Exclude transfer payments
Net Exports (X-M)
Export revenue minus import expenditure
Exports represent foreign spending on the economy’s goods and services.
Imports are the portions of C, I, and G that are spent on good and services produced abroad.
 Gross Domestic Product (GDP) by Expenditure
Components
in Current Prices (RM mil.)
Final consumption expenditure Gross fixed capital formation

Gross
Exports of Imports of
Private Private Domestic
Period Total Public sector Total Public sector goods and goods and
sector sector Product
services services
(GDP)

2017 371,436 293,040 78,396 138,393 76,577 61,816 706,382 574,172 ?

2018 ? 334,712 92,531 ? 79,801 64,834 765,370 594,655 ?

2019 434,812 338,894 95,918 136,824 65,155 71,670 ? 508,927 679,687

54
 Gross Domestic Product (GDP) by Expenditure Components
in Current Prices (RM mil.)

Final consumption expenditure Gross fixed capital formation

Gross
Exports of Imports of
Domestic
Period Total Private sector Public sector Total Private sector Public sector goods and goods and
Product
services services
(GDP)

2017 371,436 293,040 78,396 138,393 76,577 61,816 706,382 574,172

2018 427,243 334,712 92,531 144,635 79,801 64,834 765,370 594,655

2019 434,812 338,894 95,918 136,824 65,155 71,670 508,927 679,687

55
A C T I V E L E A R N I N G 1:
GDP and its components
In each of the following cases, determine how much GDP and each
of its components is affected (if at all).
A. Debbie spends $200 to buy her husband dinner
at the finest restaurant in Boston.
B. Sarah spends $1800 on a new laptop to use in her publishing
business. The laptop was built in China.
C. General Motors builds $500 million worth of cars,
but consumers only buy $470 million worth of them.
D. Jane spends $1200 on a computer to use in her editing
business. She got last year’s model on sale for a great price
from a local manufacturer.

56 56
A C T I V E L E A R N I N G 1:
Answers

A. Debbie spends $200 to buy her husband dinner

at the finest restaurant in Boston.
Consumption and GDP rise by $200.
B. Sarah spends $1800 on a new laptop to use in her
publishing business. The laptop was built in China.
Investment rises by $1800, net exports fall
by $1800, GDP is unchanged.

57 57
A C T I V E L E A R N I N G 1:
Answers
D. General Motors builds $500 million worth of cars, but
consumers only buy $470 million of them.
Consumption rises by $470 million, inventory investment rises
by $30 million, and GDP rises by $500 million.

C. Jane spends $1200 on a computer to use in her editing

business. She got last year’s model on sale for a great
price from a local manufacturer.
Current GDP and investment do not change, because
the computer was built last year.

58 58