Macroeconomics
differs from microeconomics in the mode of analysis. While the latter uses the
bottom up approach using a profit maximising firm or utility maximising
individual as the starting point, the former uses the geographic construct of an
economy as a starting point. To borrow from the forest, one can analyse the forest
from the point of the various animals, birds, reptiles, insects, plants,
shrubs, creepers, trees, herbs, caves, water bodies, soil among many other
entities found in the forest. One can analyse them individually, their
functions in a group, their interactions, etc. This is bottom up approach, thus
the micro way of analysis. The other way is to have helicopter view or bird’s
eye view of the forest. One can observe the total area the forest occupies as
percentage of landmass, the oxygen content released by the forest, the carbon
dioxide and other green gases absorbed by the forest, the amount of water by
volume in the forest, the nature of flora and fauna in the forest among the
other things. Since one is analysing through the bird’s eye view, it can be
termed as the macro approach. Hence applying to the economy, a geographic
construct in itself, microeconomic and macroeconomic approaches can be
designed.
Macroeconomic
analysis begins with the two central players, the firm and the household. The firm
produces goods and services which the household consumes. The household needs
monetary resources to engage in consumption of these goods and services which
they earn by providing factor services to the firms. The firms need to pay for
the factors of production which can be termed as factor costs. These costs are
recovered through the sales of the produced goods and services.
The household
provides factor services in form of labour services, land, money and the
entrepreneur. The firm makes use of the labour resources and pays wages to
them. Similarly the monetary resources generated from the household are
converted to build the physical capital with interest being the factor payment.
Further the land is utilised through the factor payment called rent. The entrepreneur
is in the business to earn profits, his or her factor payment. The identity
emerges from here in the form of overall factor costs through a combination of
wages, rent, interest and profit. The summation of this is what is termed as
Gross Value Added. It represents the value addition to the good or service by different
factors of production. If the profits occupy the highest share, it indicates
the entrepreneur contributed the highest share in the production relative to
the other factors of production. Since the aggregate goods were measured
through the summation of factor costs, in the earlier terminology, it was
usually referred as the GDP at factor costs.
When the firm
sells the goods, there are indirect taxes to be paid while also taking
advantage of subsidies which reduce the price. Therefore indirect taxes minus
subsidies is termed net indirect taxes which when added to the GVA is called
the Gross Domestic Product (GDP). The market value of all final goods and
services produced in an economy in a given period of time is what is
conventional definition of GDP and also referred as Aggregate Supply.
To a household,
the factor incomes thus received, becomes a source to buy goods and services
from the firm. The total amount of final goods and services consumed by a domestic
household is called Private Final Consumption Expenditure or in simple terms
Consumption. The households however do not merely consume all their income but
also save some amount for a rainy day. The savings are channelized through the
financial intermediaries. In a financial system, the intermediaries act as a
bridge between the ultimate borrowers and ultimate lenders. Households have
surplus funds but cannot find the right borrower due to the transaction costs,
the same affects the firms in deficient money. The financial intermediaries
like banks act as the bridge thus the savings are channelized into the firms as
Investment. Investment refers to asset creation in the economy as technically
termed as Gross Capital Formation.
There is a government
in the economy to which the household and the firms pay taxes in exchange for
public services and provision of public goods. The government route the taxes
back into the system as government expenditure. Further, the domestic
households also buy goods and services from abroad through imports and domestic
firms sell goods and services to the overseas households called exports.
The additive
identity of consumption, investment, government expenditure and net exports
(Exports-Imports) constitute the Aggregate Demand in the economy. It refers to
the aggregate spending that happens at an economy level thus the reflection of
the demand patterns in the economy.
While the GDP
can be taken as proxy for national income, in reality it is not so. The GDP
refers to the domestic production aggregates irrespective of the nationality of
the factors of production. The domestic nationals might produce not just in
their home country but also abroad bringing in income. This income has to be
factored in the calculation of national income. Similarly the foreign nationals
might earn income through productive activities in the domestic territory which
is not part of national income. Therefore, a new term Net Factor Income from
Abroad is calculated (Income from abroad- Income to abroad). Adding this to the
GDP will give us the Gross National Income (GNI) or Gross National Product
(GNP). Some amount capital created is utilized in the same time period thus has
to be depreciated. GNI minus
Depreciation will give the Net National Income which represents the measure for
national income.
The measures
explained above are the first step in understanding macroeconomics. The model
adopted to link the firm, household, government and external sector represents
a circular movement of money and goods thus popularly called the circular flow
of income model. An understanding of the above will create the necessary
foundations for a in-depth study of macroeconomics and the vast conclusions
that one derives from the same.
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