Macro Economics – An Introduction


Macro Economics is the branch of economics which deals with economy as a whole. It is the study of economic aggregates (macro-economic variables) such as national, income, total investment, total saving, total employment, total consumption, and general price. That is why, it has also been called “Aggregate Economics”. It is also called income, employment and monetary theory.


Difference between MICRO and MACRO

Basic Micro Macro
1. Degree of aggregation Micro economics studies the behavior of the individual units of an economy like a firm or an industry. Macro economics deals with the aggregate units of an economy such as national income, total employment, and general price level.
2. Objective It studies the principle problems, concerning the optimum allocation of resources. It studies the principle problems, policies relating to the employment of the resources
3. Instruments Its main instruments are demand and supply. Its main instruments are aggregate demand and aggregate supply
4. Alternative name It is also called ‘price theory’. It is also called income or employment theory.
5. Central problem Resources allocation and price determination. Income determination and its stabilization.



  1. Suitable for the study of an economy :Macro-economic theories helps us understand the functioning the entire economy. For e.g. macro-economic theories are used to explain national income determination, inflation, taxation, implications within the economy.
  2. Helpful in the study of economic problems and policy formulation :Economic problems can be inflation, deficit in the B.O.P., fiscal deficit in the economy. Once the economics problems have been identified and analyzed macro-economic can be used to put forward solutions to these problems which comes in the form of government, decisions.


Interdependence of Micro and Macro Economics

The two branches of economics are interdependent to each other. For e.g. when an industry changes the wage rate, it effects the general wage rate of the economy. As the general wage rate in the economy is impacted, it influence the overall employment and output in the economy.



Various activities like production consumption and investment is known as economic activities.

Production :The process through which row material is converted into output units of help of factors of production.

            Consumption :Consumption is defined as utilizing goods and services to satisfy human want. The principle activity of the household is consumption.

            Capital Formation :Capital formation is defined as excess of production over consumption.


Production = Consumption + Capital formation.



There are 4 sectors in an economy!

(a)        Household :Household is the sector that owes the various factors of production. Households supply these factors of production to the firm & in return receive factor income from them which is spend on goods and services produced by the firms.

(b)        Firms :The production is the primary activity. Firm is the sector that produces goods and services by acquiring factors of production from households. Income generated is given to the factors of production as a factor payment.

(c)        Government :Govt. receives the taxes from the households and the firms. The money’s used to provide. Services such as – police defense, medical facilities etc. General govt. is the provider of the services that improves the welfare of the people.

(d)        External Economy/Rest of the world :The difference sectors of the economy transact with rest of the world. When goods and services are purchased from rest of the world (ROW), it is termed as imports. When goods and services are sold to ROW, it is termed as exports.



            It is generated in the firms and flows to difference sectors of the economy and returns back to the firms as a revenue.

Firm undertake the production with the help of land, labour capital and entrepreneur ship and generate the output. By selling the output, firm receives income. This income is distributed among factors of production as rent, wages, interest and profit. Distributions of income give rise to the demand, for the produced goods and services. To satisfy their want households make the expenditure and dispose off their income. This expenditure goes back to the firm as revenue.




  1. Two Sector Model

            In two sector model, it is assumed that there are 2 sectors in an economy. The interaction between these 2 sectors takes place in 2 markets – factor market and product market.

In the factor markets, firms pay factor income such as rent, wages, profit and interest. Since households are the owners of the factors of production, so they receives there factor incomes.

In the product, markets, goods are supplied by the firms. Households use their factor incomes to purchase their goods and services.

There are 2 types of flows in 2 sector model :

  • Money flow :It refers to the flow of money that takes place in an economy.
  • Real flow : This shows the flow of the actual goods and services between 2 sectors of an economy.

Money flow and Real flow always equals at each other.


  1. Two Sector Model with Financial Sector

Savings are the retained income that are not used in the purchase of gods and services. Savings reduces the amount of money that households can spent on goods and services. Thus savings are the withdrawl or leakage form the circular flow of income. Most of the households either keep them in the form of deposits with banks or put them in mutual funds etc. Financial institutions such as, banks, mutual funds, insurance companies are collectively called financial sector. Thus, households savings flow into the financial sector of the economy.

Firms use the money (money available from the financial sector) to make investment. Investment is the expenditure that is incurred on capital goods. Investment is also termed as capital formation. Investment increases the productive capacity of the economy in the future.

Since the investment expenditure, increases the flow of income, they are called injections into the circular flow of income.

Equilibrium of this Model

The circular flow of income will be in equilibrium only when savings of households are equal to the investment of made by the firm.



  1. Three Sector Model

            In three sector model, the sector involved are! Households, firms, government.

Govt. collects the taxes from households and firms. Thus, taxes are the withdrawls or leakage from the circular flow of income.

In order to provide, social services such as defense, medical, education etc., the government also purchases factor services and goods from households and firms. Government pays for the factor service and goods purchased. These expenditure made by the government increases the income within the economy. Therefore government payments are injections and taxes are the leakages from the circular flow of income.

The government also make transfer payments to both households and firms. These are unilateral payments. Such as old age pensions, scholarship etc. to the households and subsides to the firms. These transfer payments are like the injections in the circular flow.

In 3 sector model, the circular flow will be in equilibrium, when savings and taxes are equal to the investment and government expenditure. i.e. total leakages equals to total injections.



  1. Four Sector Model

            Four sectors included are firms, households, govt. and rest of the world.

Firms and households purchases goods from rest of the world, known as imports. When payments are made of these imports, firms and households have less money to spent on goods and services produced within the domestic territory. Thus, imports are like leakages in the circular flow of income.

Rest of the world also purchases, goods and services from the domestic territory. Thus, households and firms get factor income from abroad known as export receipts. Since, it is in an additional income flowing in the circular flow, it is known as injections.

In the 4 sector model, the economy will be in equilibrium when all the leakages are equals to injections

Savings + Tax + Import = Investment + Government exp. + Export