CHAPTER 1ST MACRO ECONOMICS & CIRCULAR FLOW OF

INCOME

Macroeconomics is that branch of economics which deals with aggregates or issues related
to the economy as a whole. It is concerned with the determination of aggregate output and
general price level in the economy as a whole.
It studies the problems at the level of an economy such as, problems of inflation,
unemployment, etc., which are not the problems of only one individual.

Note Macroeconomics emerged as a separate branch of economics in the year 1936, with
the publication of 'The General Theory of Employment, Interest and Money' as
propounded by British economist John Maynard Keynes (J.M Keynes) father of
macroeconomics.

Subject Matter of Macroeconomics

The study of macroeconomics includes:

(i) Theory of employment It studies determination of employment in the economy, which

further includes study of full employment, underemployment, voluntary and involuntary
unemployment, etc.
(ii) Theory of National Income determination. It studies determination of domestic
income and National Income by different methods.
(iii) Theory of general pricing Issues related to inflation, deflation, excess demand, deficient
demand, etc are studied under this theory.
(iv) Theory of money It explains the important role of money and banking in the
functioning of the economy
(v) Theory of international trade It studies all international transactions between home
country and rest of the world. Determination of foreign exchange rate also comes under
the subject matter of macroeconomics.

Importance of Macroeconomics
Macroeconomics has a very wide scope. It is important because:

i) It helps in policy formulation of government.

(ii) It helps to understand the distribution of income among different groups of people.
(iii) It has special significance in studying monetary problems that adversely affects the
economy.
(iv) It facilitates international comparison.
Note The central issues in macroeconomics are related to the overall level of employment,
growth rate of national output, general price level and stability of the economy.

The Great Depression of 1929

The period from 1929 to 1933 is called the period of Great Depression. In this period, there
was huge fall in the levels of output and employment in the countries of Europe and North
America. Demand for goods in the market was low, many factors of production were lying
idle, workers were thrown out of their jobs. Unemployment rate went up from 3% to 25%
in USA.
Almost all the economies of the world faced the problems of deficient demand.

STOCK, FLOW & CIRCULAR FLOW OF INCOME

STOCK

STOCK refers to that variable or any quantity which is measured at a particular point of time.
It must be noted that stock variable do not have any time dimension.

Examples of stock variable are;

1. Goods in warehouse on 31 Mar, 2023, 2. National wealth, 3. National capital, 4. No. of

machines in a plant, 5. Money supply, 6. Amount in the bank account on a specific date, 7.
Population of India as at 31 Mar. 2022.

FLOW

FLOW refers to that variable which is measured over a period of time. It must be noted that
flow variable always has a time dimension.

Examples of flow variable are;

1.Production during month of March, 2. Birth rate of a year, 3. Population of India in the month of
March, 4. Money in bank account during the month of March 2022, 5. Profits and losses, 6. Savings,
7.national income, 8. GDP, 9.investment or capital formation.

To Sum Up:
The amount of water in a tank is the quantity of water in a tank at a particular point of
time, so it’s a stock whereas, water flowing into the tank from a tap is a flow of water bcoz
it is measured over a period of time
 IT MUST BE NOTED THAT, CAPITAL IS A STOCK CONCEPT WHEREAS INVESTMENT IS A
FLOW CONCEPT BECAUSE INVESTMENT INCLUDES REGULAR INCOME ALSO.

CIRCULAR FLOW OF INCOME;

It refers to an unending cycle of generation of income in the production process, its

distribution among factors of production and finally its circulation from households to
firms in the form of consumption expenditure on goods and services produced by firms.

FACTORS (LAND , LABOUR , CAPITAL AND ENTREPRENEUR)

EXPENDITURE ON GOODS AND SERVICES

HOUSEHOLDS FIRMS

FACTOR PAYMENTS(RENT, WAGES, SALARY, INTEREST AND

PROFITS)

GOODS AND SERVICES

PHASES OF CIRCULAR FLOW OF INCOME

1.) GENERATION PHASE/ PRODUCTION PHASE

In this phase firms produce goods and services with the help of factors of production/
factor services.

2.) DISTRIBUTION PHASE/ INCOME PHASE

This phase involves flow of factor income from firms to households for hiring factor
services. It includes rent, wages, salary, interest and profits.

3.) DISPOSITION PHASE/ EXPENDITURE PHASE

In this phase the income received by the households is spent on goods and services
produced by firms.

SECTORS INVOLVED IN CIRCULAR FLOW –

HOUSEHOLDS TWO SECTOR

PRODUCERS/FIRMS

GOVERNMENT THREE SECTOR

ABROAD FOUR SECTOR

1.)HOUSEHOLD SECTOR – it includes consumers of goods and services and also the
owners of factors of production. They supply factors like land, labour, capital and enterprise
and receive income in return called as rent, wages, salary, interest and profits
respectively.

2.)PRODUCING SECTOR (FIRMS) – it includes all producing firms in the Economy.

To produce goods and services, the firm hires factors of production from the households.
Household consumes goods and services to satisfy their wants and firms produce
goods and services to make profits.
 3.)GOVERNMENT SECTOR – it acts in two capacities, (a) as a welfare agency, it is
involved in maintaining law and order, defence and other services of public welfare. (b)
as a producer, it produces goods and services in public sector enterprises.

4.)FOREIGN SECTOR/EXTERNAL SECTOR – it is also called as rest of the world. This

sector includes transactions with the rest of the world. It is involved in export and
import of goods and flow of capital between domestic economy and other countries of the
world.

On the basis of above content, we can say that there are two type of Economies

A.) OPEN ECONOMY – it is an economy which has economic relations with the abroad.
It includes four sector economy.

B.) Closed Economy – it is an economy which has no economic relations with the abroad.
It involves two sector and three sector Economy. It does not includes foreign sector.

CIRCULAR FLOW OF INCOME IN TWO SECTOR ECONOMY

A simple economy assumes the existence of only two sectors i.e household
sector and firm sector.

Households are the owners of factors and consumers of goods and services
whereas, producers produce goods and services and sell them to households.

It is also known as closed economy and there is no involvement of government and

abroad.
ASSUMPTIONS OF CIRCULAR FLOW OF INCOME IN TWO SECTOR
ECONOMY;
1.) There are only two sectors in the economy i.e household and firm sector. There is no
government and abroad.

2.) Household sector supplies factor services only to firms and firms hire factors only from
households.

3.) Firms produce goods and services and sell the entire output to households.
4.) Household receive factor income for their factor services and spend the entire amount
on consumption of goods and services.

5.) There are no savings in the economy which means neither the households save from
their income nor the firms save from their profits.

FACTORS (LAND , LABOUR , CAPITAL AND ENTREPRENEUR)

EXPENDITURE ON GOODS AND SERVICES

HOUSEHOLDS FIRMS

FACTOR PAYMENTS(RENT, WAGES, SALARY, INTEREST AND

PROFITS)

GOODS AND SERVICES

The outer loop is known as real flow and the inner loop is known as money flow.
 Production phase

Distribution phase

Disposition phase

TYPES CIRCULAR FLOW OF INCOME

REAL FLOW MONEY FLOW

REAL FLOW/PHYSICAL FLOW;

It refers to the flow of factor services from households to firms and corresponding flow of
goods and services from firms to households. It is also known as physical flow.

REAL FLOW determines the magnitude or amount of growth process in an economy.

When more factor services are offered to firm then volume of production will be more and
thus economic growth will increase.
FACTORS (LAND, LABOUR , CAPITAL AND ENTREPRENEUR)

HOUSEHOLDS FIRMS

GOODS AND SERVICES

MONEY FLOW/NOMINAL FLOW
It refers to the flow of factor payments from firms to households and corresponding flow
of money from households to firms in the form of consumption expenditure. It is also
known as nominal flow.

It involves exchange of money between households and firms.

EXPENDITURE ON GOODS AND SERVICES

HOUSEHOLDS FIRMS

FACTOR PAYMENTS

LEAKAGES
It refers to withdrawal of money from the circular flow of income. When households and
firms save a part of their incomes, it leads to leakages in the circular flow. It refers to that
part of the income which do not pass through the circular flow of income.

INJECTIONS
It refers to introduction of income into the circular flow of income. When households and
firms borrow money from financial institutions then it adds to their income.

CONCLUSION OF CIRCULAR FLOW……

1.) Total production by firms = Total production by households.

2.) Factor payments = factor incomes.

3.) consumption expenditure = factor incomes

4.) Real flow = Money flow.

Q. NATIONAL PRODUCT is always equal to NATIONAL INCOME? HOW
(Very important)

ANS. National product means all final goods and services produced in an economy
during an accounting year. Money value of these goods and services are distributed
among the factors of production in the form of rent, wages, salaries, interest and profits.
Sum total of all these factor incomes are called national income. So national product is
always equal to national income.

SOME QUESTIONS OF CHAPTER 1ST;

Q.1) Why flow of income is always circular in two sector economy?

ANS. In the circular flow of income, production generates factor income, which is
converted into expenditure. This flow of income always continue because
production is a continuous activity as human wants are unlimited. It makes the
flow of income circular.

Q.2) NATIONAL PRODUCT is always equal to NATIONAL INCOME? HOW

(Very important)

ANS. National product means all final goods and services produced in an
economy during an accounting year. Money value of these goods and services
are distributed among the factors of production in the form of rent, wages,
salaries, interest and profits. Sum total of all these factor incomes are called
national income. So national product is always equal to national income.

Q.3) What are the contents of real flow?

ANS. factor flow and product flow

Q.4) Capital and wealth is a stock while capital formation is flow?

ANS. True, capital and wealth is always measured at a particular point of time
while capital formation is measured over a period of time.