Introduction to Macroeconomics | CBSE Class 12 Economics Notes

This note covers macroeconomics and microeconomics, economic agents, economy-wide movements, representative goods, public policy, the Great Depression, Keynes, capitalist production, factor incomes, investment expenditure, households, firms, government and the external sector.

What does macroeconomics study?

Definition: Macroeconomics studies aggregate economic variables and the interlinkages between different sectors of an economy. Aggregate variables describe the economy as a whole, such as its total production and level of employment.

Questions about the whole economy

Output means the goods and services produced. Macroeconomics asks how output, prices and employment behave across the economy. It considers whether prices as a whole will rise or fall and whether employment conditions are improving or worsening.

It also asks which indicators can show whether the economy is doing better or worse. Another concern is what steps the State, meaning government here, can take, or people can ask for, to improve the condition of the economy.

These questions concern citizens because they address the health of the country's economy as a whole. The focus extends beyond the decision to buy a particular good or the production decision of an individual enterprise.

Variables and related movements

An economic variable is an attribute, such as a price, that can change. A price is the amount charged for a good or service. The employment level concerns people engaged in work, while total production concerns the output of the economy.

The output levels of different goods and services have a tendency to move together. Growth in foodgrain output is generally accompanied by growth in industrial output. Different industrial goods also tend to show simultaneous increases or decreases in production.

Prices of different goods and services generally have a tendency to rise or fall simultaneously. Employment in different production units also goes up or down together. These relationships help explain why studying aggregate movements can be useful.

Inflation refers here to prices going up. When employment and production levels are going down, the economy is heading for a depression. During fast changes, movements for individual commodities are usually in the same general direction as movements for the economy as a whole.

How do representative goods simplify macroeconomic analysis?

Using a simplified picture

A representative good is a single imaginary commodity used to represent the many goods and services produced in an economy. Its production corresponds to their average production level. Its price and employment level reflect the general price and employment levels.

If output, price and employment levels across production units bear a close relationship to one another, analysing the entire economy becomes relatively easy. We can examine the representative good instead of separately following every commodity bought and sold.

This simplification is useful because what happens to prices and other economic attributes for one commodity generally happens, more or less, for others too. It allows macroeconomics to relate the country's total production and employment to other variables.

Recognising the limits

The representative good can hide distinctive characteristics. Agricultural and industrial commodities have different production conditions. A firm is a production unit. Treating all labour, meaning human work used in production, as one category may hide the difference between the work of its manager and its accountant.

For many purposes, a handful of categories is more useful than one. Agricultural goods, industrial goods and services can represent the commodities produced across the economy. Their production technologies and prices may differ, so their output and employment can be studied separately.

A sector is a distinct part of the economy considered in analysis. Studying the interdependence, or even rivalry, between agriculture and industry can sometimes explain economic events better than looking only at the economy as a whole.

Note: A tendency for variables to move together does not mean that every good has identical production conditions or prices. The representative good is a useful simplification, and separate sectors may need attention.

Macroeconomic analysis therefore can include differences within the economy. Its concern with the whole economy includes examining how the output, prices and employment of different broad categories of goods are determined and how sectors relate to one another.

How does microeconomics differ from macroeconomics?

Definition: Economic agents are individuals or institutions that take economic decisions. They include consumers, producers, government, corporations and banks.

Individual decisions and motivations

Microeconomics studies individual markets and the decisions of their buyers and sellers. Consumers decide what and how much to consume. Given their tastes and incomes, they choose combinations of goods that maximise their personal satisfaction or welfare.

Producers decide what and how much to produce. They try to maximise profit, the earning left to those organising production after paying for the productive resources they use. They seek low costs and the highest selling price obtainable in the market.

A large company remains a microeconomic agent when it acts in its shareholders' interests. Shareholders are the company's owners. Their interests are not necessarily the interests of the country as a whole, so physical size does not settle the distinction.

Connections between the two branches

General equilibrium means equilibrium of supply and demand in each market of the economy. Demand concerns what buyers seek to buy; supply concerns what sellers offer. Equilibrium refers to the balance between demand and supply.

General equilibrium brings microeconomics nearest to the economy-wide perspective. Macroeconomics has deep roots in microeconomics because it studies the aggregate effects of market demand and supply. It also considers policies that modify those forces when necessary to pursue choices made by society.

Why do public goals require macroeconomic policies?

Why individual self-interest is insufficient

Adam Smith, regarded as the founding father of modern economics, suggested that buyers and sellers following their self-interest would make separate consideration of the country's wealth and welfare unnecessary. Economists gradually found reasons to look further.

In some cases, markets did not or could not exist. In other cases, markets existed but failed to bring demand and supply into equilibrium. These problems challenged reliance on individual market decisions to explain the condition of the whole economy.

Society also chose to pursue important social goals unselfishly, including employment, administration, defence, education and health. Some aggregate effects of individual economic decisions therefore needed modification. Macroeconomists studied how public policies affected markets and the wider economy.

Smith was a Scotsman, a professor at the University of Glasgow and a philosopher by training. Economics was then known as political economy. His well-known work published in 1776 is regarded as the first major comprehensive book on the subject.

His discussion of the butcher, brewer and baker connects the provision of dinner with their pursuit of their own advantage. This passage is often cited as support for a free market economy, in which buyers and sellers act through markets.

Who makes these decisions?

Macroeconomic policies are pursued by the State or statutory bodies, institutions with roles defined by law. Examples include the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI).

Typically, each body has one or more public goals defined by law or the Constitution of India. These goals differ from the private profit or personal welfare sought by individual economic agents. Macroeconomic decision-makers often have to go beyond economic objectives.

Policies can involve taxation and other budgetary choices, meaning government decisions about taxes and spending. They can also seek changes in money supply, the amount of money available, and in interest, wages, employment and output. Interest is payment to capital, the resources supplied or borrowed to run production. Wages are payments for labour services.

In a developing country like India, public choices include removing or reducing unemployment, improving access to education and primary health care for all, providing good administration and providing sufficiently for defence. Resources are directed towards public needs and collective welfare.

Note: The distinction involves both the decision-maker and the objective. State institutions pursue public goals; individual consumers and producers are analysed as pursuing their own satisfaction or profit.

How did the Great Depression lead to the emergence of macroeconomics?

The challenge to the classical tradition

The classical tradition was the dominant economic thinking before Keynes. It held that all labourers ready to work would find employment and all factories would operate at full capacity. The Great Depression challenged this understanding of the economy.

The Great Depression began in 1929 and continued in subsequent years. Output and employment fell by huge amounts in Europe and North America. Other countries were affected as well. Market demand was low, many factories lay idle and workers lost jobs.

The unemployment rate may be defined as the number of people not working and looking for jobs divided by the total number working or looking for jobs. The denominator therefore includes both people in work and people seeking work.

Keynes and the whole economy

John Maynard Keynes, a British economist, published The General Theory of Employment, Interest and Money in 1936. Macroeconomics emerged as a separate branch of economics after its publication. The Depression had shown that an economy may experience long lasting unemployment.

Keynes attempted to explain this possibility by examining the economy in its entirety and the interdependence of its sectors. The question was how the whole economy could continue with idle factories and people unable to find work.

Cartoon: People carrying containers queue outside a building marked “WELFARE RELIEF DEPT.” At the front, food is being weighed for distribution.

Keynes was born in 1883 and educated at King's College, Cambridge, in the United Kingdom. He later became its Dean. Alongside his intellectual work, he was actively involved in international diplomacy during the years following the First World War.

His The Economic Consequences of the Peace, published in 1919, predicted the breakdown of the War's peace agreement. His 1936 work on employment, interest and money is regarded as one of the most influential economics books of the twentieth century.

Aggregate output in the USA fell by approximately 33 per cent from 1929 to 1933. The unemployment rate concerns those working or looking for work, rather than the total population.

What are the important features of a capitalist economy?

Definition: A capitalist economy is one in which most economic activities involve private ownership of production resources, production for market sale, and buying and selling labour services at a wage rate, meaning the price of those services.

Ownership, markets and labour

Means of production are the resources used to produce goods and services, including land, meaning natural resources, and capital, such as productive equipment. In a capitalist economy these are privately owned in most economic activities. Production is undertaken to sell output in the market.

Wage labour is labour sold and purchased in return for wages. The wage rate is the price paid for labour services. Hiring workers is therefore part of the organisation of capitalist production, alongside the use of land and capital.

Capitalist production is mainly carried out by enterprises. An entrepreneur controls major enterprise decisions and bears a large part of the associated risk. A typical enterprise may have one entrepreneur or several, who organise resources and undertake production.

Limits of this economic setting

These characteristics do not describe every production arrangement. In many underdeveloped countries, especially in agriculture, peasant families carry out production. Wage labour is seldom used, and most labour comes from family members. A great part of output is consumed by the family.

Such production is not solely for the market. Nor do many peasant farms experience a significant rise over time in capital stock, the capital available for production. These features distinguish them from the capitalist production setting being examined.

In many tribal societies, ownership of land does not exist in the same form; land may belong to the whole tribe. Analysis built around capitalist production will not apply to those societies. Many developing countries nevertheless have a significant presence of production units organised on capitalist principles.

Note: Keep the qualification “most” when defining a capitalist economy. An analysis centred on capitalist production may not be entirely able to capture how a developing country functions.

How do firms organise production and distribute income?

Inputs and the entrepreneur

A firm is a production unit organised according to capitalist principles. Its entrepreneur hires wage labour and employs land and capital. Inputs are the resources used in production. They help the firm produce goods and services for market sale.

Capital is the resource supplied or borrowed to run the enterprise, including its productive equipment. Land refers to natural resources used in production. Some natural resources, such as raw materials, are consumed; others, such as plots of land, remain fixed.

Labour is the human work needed for production. Land, capital and labour are the three factors used by the entrepreneur in producing output. A factor of production is a resource contributing to production. Entrepreneurship organises these resources and bears risk.

From sale proceeds to factor incomes

Revenue is the money earned by selling output. Part is paid as rent for land, part as interest to capital, and part as wages to labour. The remainder is the entrepreneur's profit.

Investment expenditure includes expenses that raise productive capacity, such as buying new machinery or building new factories. Profits are often used for these purposes in the next period so that production can expand.

The entrepreneur undertakes risks and uncertainties while seeking profit. For example, the output may not fetch a high enough price, which may reduce profits. The pursuit of profit therefore does not guarantee that the expected earning will be obtained.

In a capitalist country, factors earn income through production and the sale of the resulting output. This connects decisions inside the firm with incomes received elsewhere in the economy. Production, sale proceeds and the distribution of income belong to the same economic process.

How do households and government participate in the economy?

Households as consumers and income earners

Definition: A household is an individual who makes decisions about her own consumption, or a group whose consumption decisions are jointly determined. Consumption concerns the goods and services people use.

Households consume, save and pay taxes. Saving means retaining income instead of using it for current consumption. Taxes are payments imposed by government. Household members obtain the money for these activities through several kinds of income.

They work in firms and earn wages, or in government departments and earn salaries, meaning payments for their employment. They may own firms and earn profits. They can also receive rent by leasing land or interest by lending capital.

The demand coming from households is necessary for the functioning of markets in which firms sell their products. Households therefore participate on both sides of the relationship: their members receive incomes from production and buy goods and services produced by firms.

Government as a major sector

Government denotes the State in this economic analysis. It exists alongside the private capitalist sector in both developed and developing countries. Its roles include making laws, enforcing them and delivering justice.

Government also undertakes production in many instances. It imposes taxes and spends on public infrastructure, meaning facilities provided for public use. Other activities include running schools and colleges and providing health services.

These economic functions must be included in an account of a country's economy. An explanation limited to private firms and their customers would leave out government production, taxation, expenditure and the incomes earned by people working in government departments.

The household and government sectors also connect private choices with public decisions. A person may earn a government salary, make household consumption decisions and pay taxes. Examining these relationships helps reveal the interdependence that macroeconomics seeks to understand.

How does the external sector connect with the domestic economy?

Trade and movements of capital

The domestic economy is the economy of the country being studied. The external sector is the rest of the world in its economic relations with that country. Countries engage in external trade, involving sales to and purchases from other countries.

Exports are goods sold by the domestic country to the rest of the world. Imports are goods bought by the domestic economy from the rest of the world. The distinction depends on whether the domestic country is selling or buying.

The rest of the world also affects the domestic economy through capital flows, movements of capital between countries. Foreign capital may enter the domestic country, or the domestic country may export capital to foreign countries.

These connections make the external sector the fourth important sector alongside firms, households and government. Considering all four helps explain relationships that would be missed by examining a single domestic market in isolation.

Putting the four sectors together

The four-sector view and the representative-good approach answer different analytical needs. A representative good simplifies movements across commodities. A sectoral view highlights how different parts of the economy interact through production, income, consumption and other economic decisions.

Macroeconomic interdependence means that sectors are connected rather than considered separately with everything else unchanged. Macroeconomics examines these connections alongside aggregate variables. Microeconomics mostly examines particular sectors while assuming that the rest of the economy remains the same.

Glossary

• Macroeconomics — Study of aggregate economic variables and interlinkages between the different sectors of an economy.
• Microeconomics — Study of individual markets and the economic decisions of their buyers and sellers.
• Economic agents — Individuals or institutions that take economic decisions about consumption, production or other economic activities.
• Representative good — An imaginary commodity used to represent production, prices and employment across many goods and services.
• General equilibrium — The equilibrium of supply and demand in each market within the economy.
• Unemployment rate — People not working and looking for jobs divided by all people working or looking for jobs.
• Capitalist economy — Economy where most activities involve private production resources, market-oriented output and the purchase and sale of labour services.
• Entrepreneur — Person controlling major enterprise decisions and bearing a large part of the risks associated with production.
• Wage labour — Labour services sold and purchased in return for a payment called wages.
• Profit — The entrepreneur's earning remaining from revenue after payments to land, capital and labour.
• Investment expenditure — Expenditure that raises productive capacity, such as spending on new machinery or new factories.
• Household — An individual deciding her own consumption, or a group whose consumption decisions are jointly determined.
• External sector — The rest of the world connected with the domestic economy through trade and capital movements.
• Exports — Goods sold by the domestic country to the rest of the world.
• Imports — Goods bought by the domestic economy from the rest of the world.

Common errors and misconceptions

• Misconception: A large company is automatically a macroeconomic agent. Correct: It remains microeconomic when acting for its shareholders, whose interests are not necessarily those of the country as a whole.
• Misconception: A representative good proves that all commodities are identical. Correct: It simplifies analysis and may hide important differences in production conditions, prices or kinds of labour.
• Misconception: Macroeconomics has no connection with microeconomics. Correct: It has deep microeconomic roots because it examines aggregate effects of demand and supply as well as policies that may modify those forces.
• Misconception: The unemployment rate uses the whole population as its denominator. Correct: Its denominator comprises people working or looking for jobs.
• Misconception: Every activity in a capitalist economy must have the same organisation. Correct: The definition applies to most economic activities, and the State also has economic functions.
• Misconception: Revenue and profit mean the same thing. Correct: Revenue is money earned from output sales; profit remains after payments for the services of land, capital and labour.
• Misconception: All profits necessarily finance expansion. Correct: Profits are often used to buy machinery or build factories.
• Misconception: The external sector concerns imports and exports alone. Correct: Capital may also flow into the domestic country or from it to foreign countries.

Exam-style questions with model answers

Q1. What are economic agents? Give examples of their decisions. [2 marks]

1. Economic agents are individuals or institutions that make economic decisions, including consumers, producers, governments, corporations and banks.
2. Consumers decide what and how much to consume; producers decide what and how much to produce.

Q2. Explain three differences between microeconomics and macroeconomics. [3 marks]

1. Microeconomics studies individual markets and their buyers and sellers. Macroeconomics studies aggregate variables and situations facing the economy as a whole.
2. Microeconomic analysis considers consumers seeking satisfaction and producers seeking profit. Macroeconomic policy-makers pursue public goals and the welfare of the country and its people.
3. Microeconomics mostly examines particular sectors with the rest of the economy unchanged. Macroeconomics also studies interlinkages between sectors and policies affecting aggregate conditions.

Q3. State three important features of a capitalist economy. [3 marks]

1. Most economic activities involve private ownership of the means of production. These means are resources, such as land and capital, used to produce goods and services.
2. Production is undertaken to sell the output in the market. Firms organise productive resources with the motive of earning profits through these sales.
3. Labour services are sold and purchased at a price called the wage rate. Labour sold and purchased in return for wages is called wage labour.

Q4. Describe the four major sectors of an economy and their economic activities. [4 marks]

1. Firms organise production by employing land, capital and wage labour. Entrepreneurs sell the resulting output in the market with the aim of earning profits.
2. Households make consumption decisions, save and pay taxes. Their members earn wages, salaries, profits, rent or interest through different economic roles.
3. Government frames and enforces laws, delivers justice, taxes and spends. It provides public services and also undertakes production in many instances.
4. The external sector connects the domestic economy with the rest of the world through exports, imports and movements of capital between countries.

Q5. During 1929 to 1933, unemployment in the USA rose from 3 per cent to 25 per cent and aggregate output fell by about 33 per cent. Low demand, idle factories and job losses affected Europe and North America, and other countries were affected too. Using these facts, explain how the Great Depression challenged classical thinking and encouraged Keynes's economy-wide approach. [5 marks]

1. The classical tradition held that all labourers ready to work would find employment and all factories would operate at full capacity. The supplied conditions challenged this expectation.
2. The increase in the USA unemployment rate from 3 per cent to 25 per cent showed a severe worsening of employment conditions during the stated period.
3. The fall in aggregate output by about 33 per cent, alongside low demand and idle factories, showed that productive capacity was not being fully used.
4. Job losses across the affected economies made economists consider that unemployment could last for a long time and required an explanation of how the economy functioned.
5. Keynes examined the economy in its entirety and the interdependence of different sectors. His approach sought to explain the persistence of unemployment revealed by such conditions.

Q6. Explain six aspects of capitalist enterprise: entrepreneurial control, capital, natural resources, labour, distribution of revenue and investment expenditure. [6 marks]

1. One or several entrepreneurs control major decisions and bear a large part of enterprise risk. They organise production with the aim of selling output and earning profits.
2. Entrepreneurs may supply the capital required to run the enterprise themselves, or they may borrow it. Capital is one of the resources used in production.
3. Production also needs natural resources. Raw materials are consumed during production, whereas plots of land are a fixed natural resource used by the enterprise.
4. Human labour performs the work needed for production. The entrepreneur hires wage labour from the market and combines its services with land and capital.
5. Sales bring revenue. Rent is paid for land, interest to capital and wages to labour. The remaining revenue is the entrepreneur's earning, called profit.
6. Profits are often used in the next period to buy machinery or build factories. Such expenditure raises productive capacity and is an example of investment expenditure.

Q7. Explain three reasons why macroeconomic policy may need to modify the aggregate effects of individual market decisions. [3 marks]

1. In some cases, markets do not or cannot exist. Individual buying and selling therefore cannot by themselves provide a complete basis for analysing the economy.
2. In other cases, markets exist but fail to produce equilibrium of demand and supply. Their aggregate effects consequently require further investigation.
3. Society may pursue social goals unselfishly in employment, education, health, administration or defence. Achieving these goals may require modifying outcomes arising from individual decisions.

Q8. Why is the representative-good approach useful, and what is one limitation? [2 marks]

1. It simplifies analysis because output, prices and employment across goods generally have related movements, allowing an imaginary commodity to represent the economy.
2. It may overlook distinctive characteristics, such as different production conditions for agricultural and industrial goods.

Key takeaways

• Macroeconomics studies aggregate economic conditions and the interdependence of sectors, including changes in output, prices and employment.
• A representative good simplifies analysis, but differences between agricultural goods, industrial goods and services may require separate attention.
• Microeconomic agents pursue personal satisfaction or profit; macroeconomic policy-makers pursue public goals and the welfare of the country.
• The Great Depression challenged classical expectations of employment and full factory use, encouraging an explanation of long lasting unemployment.
• Keynes's 1936 book helped establish macroeconomics as a separate branch examining the whole economy and the interdependence of its sectors.
• Most activities in a capitalist economy involve private production resources, market sales and the sale and purchase of labour services.
• Rent, interest and wages are paid from sales revenue; the remainder is profit, which is often used for investment expenditure.
• Households, firms, government and the external sector interact through production, income, consumption, public activities, trade and capital movements.

Test yourself

Why is a large company still a microeconomic agent?

It acts in the interests of its shareholders, which are not necessarily the interests of the country as a whole.

Which three commodity categories can replace a single representative good?

Agricultural goods, industrial goods and services can represent the different commodities produced within the economy.

What belongs in the denominator of the unemployment rate?

The total number of people who are working or looking for jobs, rather than the entire population.

What did the classical tradition expect about workers and factories?

All labourers ready to work would find employment, and all factories would operate at their full capacity.

How do revenue and profit differ?

Revenue is money earned from selling output. Profit is the part remaining after payments as rent, interest and wages.

What makes expenditure on new machinery an investment expenditure?

Buying new machinery can raise productive capacity, allowing production to expand in the next period.

Can one individual constitute a household?

Yes. An individual making decisions about her own consumption is a household; a group with jointly determined consumption decisions also qualifies.

How can the external sector affect the economy besides trade?

Capital from foreign countries may enter the domestic country, or the domestic country may export capital to foreign countries.