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MACROECONOMICS Simplified – Edilberto B. Viray Jr. / Ma. Jesusa Avila – Bato / Lucky Raymundo M.

Malveda - 2016

CHAPTER 1
MACROECONOMICS FUNDAMENTALS

LEARNING OBJECTIVES
This chapter is all about macroeconomic fundamentals. After reading this chapter, you will be able to:
1. Understand the role of the government
2. Learn about production possibilities
3. Identify reasons for economic growth
4. Appreciate the circular flow model
5. Comprehend important concepts and definitions

What is macroeconomics all about? Generally, people would associate it with anything having to do with
money and how to make as much of it as possible. Others claim that it deals with making choices and
facing trade-offs.
- Still, others associate it with government fiscal and monetary policies and how they can help in
sustaining a country’s economic health.
- Of course, macroeconomics covers all these and other aspects of economics like aggregate
production, general prices of goods and services, employment, to name a few.
- In addition, the 5 Goals of Macroeconomics” will be discussed in the succeeding chapters:

5 Goals of Macroeconomics
1. Sustained economic growth
2. Price stability
3. Full employment
4. Trade balance
5. Redistribution of income

The real purpose of macroeconomics is to explain our condition as a nation and finding ways to optimally
use our resources in order for us to achieve the highest standard of living possible.
- Several definitions of macroeconomics have been formulated for centuries.
- However, for our purposes, macroeconomics is the study of how we can increase our country’s
wealth given the available resources we have and develop, these resources into goods and
services in the best possible way in order to satisfy our needs and wants.
- Wealth in this definition includes tangibles like cars, houses, appliances, and condominiums as
well as intangibles like more leisure time, cleaner air, and the like.

As you may have noticed, there is quite a disagreement over how a country should go about achieving
the optimum amount of wealth.
- Some economists promote a great amount of government involvement, price controls, active
monetary policy, and so on.
- Others, on the other hand, believe that government involvement should be minimal and limited
to tasks related to defending individual rights, national defense and security, maintenance of
peace and order, and so on.
MACROECONOMICS Simplified – Edilberto B. Viray Jr. / Ma. Jesusa Avila – Bato / Lucky Raymundo M. Malveda - 2016

- Many, however, believe that a combination of moderate government involvement and private
initiatives is deal for achieving the highest standard of living.

Moreover, there are also various opinions about the role of profits, consumer spending saving, capital
formation, minimum wage, foreign investment, taxation and government spending, public debt, and
other issues related to our economy.
- Then, there is the question of burden thus, the question of taxing goods and services or income
and profits to equally distribute the wealth of our country.
- Likewise, there is the question of whether to encourage spending and discourage saving to
stimulate our country’s economic growth.
- Also included is the question of unions increasing the welfare of the labor sector is present.
- We will discuss all of these and other important macroeconomic issues in the succeeding
chapters of this book.

THE ROLE OF GOVERNMENT


The Philippines is a mixed economy with a substantial amount of government involvement in the form of
direct government spending, taxation, regulation, and monetary policies.
- Economic conditions were not always like this.
- Changes in economic policies happen every now and then, depending upon the economic
situation brought about by national and international economic conditions.

Capital goods are an tangible assets that an organization uses to produce goods or services such as
office buildings, equipment and machinery. Consumer goods are the end result of this production
process. (Source: http//www.investopedia.com/terms/c/capitalgoods.asp)

After World War II, the Philippines experienced a dramatic change in economic beliefs about the role of
the private sector and the government.
- Subsequently, the role of the government in our country as well as in many other countries of
the world has increased considerably at the end of the war.
- Central banks, in particular, took control of the monetary system, labor unions supported by
government legislations gained more influence, social programs, such as social security and
health insurance were deemed necessary, new deal types of government spending to artificially
create jobs when the economy is slowing down became commonplace, and to fund the growing
government expenses and the exponentially growing number of government employees, taxes
to income and goods and services skyrocketed.
- Public borrowings on both domestic and foreign became the trend between developing and
developed countries that do not meet target revenues needed to support government spending.

Before we delve into the question as to whether the increased role of the government has been
beneficial to the Philippines as well as other countries, let us take a look first at some of the basic
concepts in economics that are necessary to our analysis. We start by looking at the production
possibilities frontier.
MACROECONOMICS Simplified – Edilberto B. Viray Jr. / Ma. Jesusa Avila – Bato / Lucky Raymundo M. Malveda - 2016

Since scarcity is a fact of economic life, we need to use our scarce productive resources as efficiently as
possible.
- If we succeed, we can say that we are operating as full economic capacity since all resources are
utilized in the production of goods and services needed by the people.
- Usually there is some economic slack, but very so often we do manage to operate at peak
efficiency.
- When this happens, we say we are operating on our production possibilities frontier or
production possibilities curve.

So, what is the production possibilities frontier? The production possibilities frontier represents the
outcome or production combination that can be produced with a given amount of resources.
- For instance, let us say that a very small island country currently availing itself of 100 hectares of
land with 20 machineries and 50 workers is able to produce 500 farm tractors and 350 tons of
rice at maximum with these resources.
- However with the same number of resources, it could also produce 400 tractors and 500tons of
rice.
- As another alternative, it could also produce 300 tractors and 580 tons of rice.
- Numerous other combinations, producing fractions of capital goods and consumer goods, are
possible.
- A curve representing all possible combination is illustrated in Figure 1.1, where “farm tractors”
represent capital goods and “rice” represents consumer goods.

Figure 1.1 tells us that each point on the curve. For example, Point C = 500 farm tractors and 350 tons of
rice illustrates an output combination that is produced given the 100 hectares of land, 20 machineries,
and 50 workers as efficiently as possible.
- However, every point inside the curve represents an output combination that is produced with
less than the available resources being utilized thus making other resources idle, unemployed, or
with all the resources utilized but used inefficiently or underemployed.
- For instance, Point G = 300 farm tractors and 350 tons of rice.
- Conversely, points outside of the curve or Point F indicate that such output combination is
unattainable considering the limited resources of the island country.
MACROECONOMICS Simplified – Edilberto B. Viray Jr. / Ma. Jesusa Avila – Bato / Lucky Raymundo M. Malveda - 2016

This curve shows the range of possible combinations of outputs of tractors and rice from 600 units of
tractors and no rice to 700 tons of rice and no tractors. Any point inside the curve (say point G) means
unemployed resources, while any point outside of the curve (say point F) means unattainable production
because of scare resources.

If an economy is operating at any point along the production possibilities curve, it means that all its
available resources are utilized and they are used as efficiently as possible.
- This condition is referred to as full-employment, which means that all resources available in the
economy are fully utilized in the production of good and services.
- Therefore total output is the maximum combination level that can be produced given the
existing limited resources and technology of the economy when they are fully utilized.
- It follows then that output cannot increase if resources and technology remain constant. Thus,
Point F is unattainable at this point in time.

This brings us now to the reality that the production of one particular good or category of goods can
increase but only at the expense of decreasing the production of other goods or category of goods,
which is called opportunity cost.
- A trade-off therefore happens, which means that in order for an economy to produce an
additional unit output of one good it has to forego the production of other goods.
- For instance, if the island economy in our example wishes to produce 500 tons of rice, it has
foregone 100 units of tractors in order to attain maximum production (refer to the movement
from point C to point B in Figure 1.1).
MACROECONOMICS Simplified – Edilberto B. Viray Jr. / Ma. Jesusa Avila – Bato / Lucky Raymundo M. Malveda - 2016

When economists discuss the concept of “scarcity” they refer to the economic reality that resources
are limited and that at any given point in time, output is also limited.

Over time, however, economic growth occurs when the economy realizes greater production capabilities
to produce capital and consumer goods.
- Nevertheless, for this to happen resources by way of land, labor, and capital must increase
and/or technology must improve.

Observe that most countries experience economic growth because of advances in technology and
increase in the capital stock through new investment such as additional new machinery, equipment,
factories, office buildings, and public infrastructures like roads and highways, seaports and airports are
added.
- In Figure 1.1 economic growth is illustrated by an expansion or the outward shift of the
production possibilities curve (refer to the curve as indicated by the arrows).
- Thus, at this new curve production would expand for both tractors and rice.

The United States and other industrialized countries like Japan, Korea, Taiwan, and Germany and recently
China and India have experienced significant economic growth during the latter part of the 20 th century
and early part of the 21st century.
- This simply indicates that their production possibilities curves have shifted outward considerably
primarily due to increases in their capital stock and advances in technology.
- On the other hand, economies which are mostly developing countries including the Philippines
that has insufficient capital and poor technology have experienced less economic growth and
therefore less expansion of their production possibilities curves.

REASONS FOR ECONOMIC GROWTH


We already noted in the above discussion that increases in a country’s capital stock and advances in
technology lead to economic growth.
- How does a country achieve significant increases in capital goods and advances in technology?
- Let us look at increase in capital stock first.

Capital goods like machinery, equipment, factories, and buildings are produced just like any other
consumer goods such as cars, televisions, and food items.
- At one point in time that is, given fixed amounts of resources and technology, assuming full-
employment condition, more capital goods can be produced only at the expense of producing
other goods.
- Thus, in a two-good economy, more capital goods are produced when fewer consumption goods
are produced say 500 tractors and 350 tons of rice.
- In Figure 1.1, we are moving from the lower right to the upper left of the curve, for instance,
from point A to point B or point C on the same production possibilities curve.
- As we move from one point to another point in the same curve, we give up something in order
to produce more of the good that we want.
MACROECONOMICS Simplified – Edilberto B. Viray Jr. / Ma. Jesusa Avila – Bato / Lucky Raymundo M. Malveda - 2016

Advances in technology, on the other hand, occur because of inventions and innovations in producing
goods and services. Inventions and innovations take place when entrepreneurs or producers have
incentives to produce more efficiently and minimize their costs.
- When lower costs lead to higher profits and greater rewards, entrepreneurs are motivated to
continue to improve their production process.
- Countries that allow entrepreneurs to keep all or most of these rewards by limiting taxation and
government involvement have been observed to experience greater rates of technological
growth.
- On the other hand, the economy will not grow if capital goods or technology is lacking.

THE CIRCULAR FLOW MODEL


Now that we have finished discussing the production possibilities curve, we can continue our discussion
by examining another macroeconomic model the circular flow model.
- Simply defined, the circular flow model is a simplified, exposition of money and physical or real
flows through the economy, which serves as basis for macroeconomic analysis (Pass and Love
1998). But what is the model all about?

In any case, the economy will experience growth thus its production possibility curve will shif
outward. For as long as more new capital goods are produced or new technology is utilized in the
production of goods and services, the expansion of the economy will continue.

As you may have observed, the dynamic market economy creates continuous, repetitive flows of goods
and services, resources, and money. This flow of goods and services, resources, and money can be
illustrated through the model.
- Thus, the circular flow diagram, illustrated in Figure 1.2, shows the flow of resources and output
from households to businesses, and vice versa.
- Observe that in the diagram we group private decision makers into businesses and households
and group markets into the resource market and the product market.

The upper half of the circular flow diagram represents the resource market the place where resources or
the services of resource suppliers are bought and sold. In the resource market the household sector,
which is the owner of the land, and labor, capital, sells these resources to the business sector, which buy
and use them in the production of goods and services.
- Hence, households own all economic resources either directly as workers or entrepreneurs or
indirectly through their ownership of business corporations.
- They sell their resources to businesses and acquire them because they are necessary for
producing goods and services.
- In the circular flow model, this is represented by the inner arrow from the household sector
going to the direction of the business sector.
MACROECONOMICS Simplified – Edilberto B. Viray Jr. / Ma. Jesusa Avila – Bato / Lucky Raymundo M. Malveda - 2016

- The funds that businesses pay for purchasing and using of resources are costs to businesses but
are flows of income to households in the form of wages and salaries, rent, interest, and profit or
loss.
- This is represented by the outer arrow from the business sector going to the direction of the
household sector.
- Productive resources therefore flow from households to businesses, and money flows from
businesses to households.

Conversely, the lower half of the model represents the product market the place where goods and
services produced by businesses are bought by and sold to the household sector. In the product market,
businesses combine the resources owned by the households that are land, labor, capital to produce and
sell goods and services.
- This is represented by the inner arrow from the business sector going to the direction of the
household sector.
- In return, the households use the income from selling their resources to the businesses to buy
the goods and services that the businesses produced in the form of consumption expenditure.

The figure illustrates the flow of resources and payments for their use as well as the flow of goods and
services and payment for them. Thus, the household sector sells resources to and buys products from
the business sector while the business sector buys resources from and sells products to the household
sector.
MACROECONOMICS Simplified – Edilberto B. Viray Jr. / Ma. Jesusa Avila – Bato / Lucky Raymundo M. Malveda - 2016

This represented by the outer arrow from the household sector going to the direction of the business
sector. The monetary flow of consumer or household spending on goods and services yields sales
revenues for businesses.
- Businesses compare these revenues to their costs in determine profitability and whether or not
a particular good or service should continue to be produced and sold.

Nevertheless, the circular flow model depicts a complex, interrelated web of decision making and
economic activity involving businesses and households. For the economy, it is the circle of life.
- Businesses and households are both buyers and sellers.
- Businesses buy resources and sell products.
- Households buy products and sell resources.
- As shown in Figure 1.2., there is a counterclockwise real flow of economic resources and finished
goods and services and a clockwise money flow of income and consumption expenditures.

In the real world however, the economy is not merely composed of the household and business sectors.
We can therefore expand and develop our basic model to incorporate a number of “injections” or
“inflows” to and “withdrawals” or “outflows” from the income flow by adding other sectors such as the
government, and the rest of the world. Our new circular flow model is illustrated in Figure 1.3.

Observe that not all of the income received by households is spent – some are saved. Savings is a
withdrawal or outflow from the income flow.
- Generally, the money saved by households is placed in the capital market such as banks, the
stock market, and other financial intermediaries like insurance.
- The money saved by the households will now become a source of funds for the business sector.
- In other words, the money saved by the household can only return back to the circular flow
when businesses utilize it to fund new and additional investments.
- Investment expenditures on new plant and machinery, buildings and factories therefore inject
funds or an inflow into the income flow.
- We can therefore say that whatever the household sector save in the capital market can only
return back to the circular flow if the business sector will utilize it in the form of investment.

Take note also that part of the income accruing to households is taxed by the government and serves to
reduce disposable income available for consumption expenditures.
- Taxes can be direct like individual income tax, corporate and income tax or indirect such as value
added tax, and excise taxes.
- Thus, if the government imposes a 10 percent tax on your income, you disposable income will be
less by the rate of tax.
- Taxation therefore is a withdrawal or outflow from the income flow so that whatever amount of
tax is paid by the households goes back to the income stream through government
expenditures.
MACROECONOMICS Simplified – Edilberto B. Viray Jr. / Ma. Jesusa Avila – Bato / Lucky Raymundo M. Malveda - 2016

Households likewise spend some of their income or imported goods and services. Imports are therefore
withdrawals from the income flow.
- Thus, if we import oil from Saudi Arabia or cars from Japan, a portion of our income goes out of
our economy since we have to pay these imported products out of our own income.
- On the other hand, some of our output is sold to overseas customers.
- Hence, exports represent a demand for domestically produced goods and services by foreign
countries and therefore constitute an injection into the income flow.

This figure illustrates a more complex model of the circular flow of national income, incorporating
injections to and withdrawals from the income flow as well as the three other main sectors of the
economy interacting together in order to achieve equilibrium level of national income.

IMPORTANT CONCEPTS AND DEFINITIONS


It is helpful at this point to clarify a few macroeconomic concepts which are important in our analysis
later in other course.
MACROECONOMICS Simplified – Edilberto B. Viray Jr. / Ma. Jesusa Avila – Bato / Lucky Raymundo M. Malveda - 2016

Nominal versus real values. When we refer to nominal values, such as nominal prices, earnings, wages,
or interest rates, we refer to the peso value of the prices, earnings, wages, or the absolute value of the
interest rates.
- For instance a person earning P404.00 a day is said to be earning a nominal wage of P404.00 or
an interest rate at 12 percent per annum charged by creditors on loans is the nominal cost of
borrowing money annually.

Real values on the other hand, are always values in comparison, or relative, to other related economic
variables. Thus a person earning a nominal wage of P404.00 in 2011 may only be earning a real wage of
say P192.50 relative to today’s doubled prices, since 2001.
- Applying the concept on interest rate, a 12 percent nominal interest rate is only 2 percent real
interest rate if prices are rising by 10 percent.

Positive versus normative economics. As we have discussed, positive economic statements are facts or
relationships which can be proven or disproven.
- Normative economic statement is someone’s opinion or a value judgment about an economic
issue. Such a statement can never by proven.
o A normative statement is one, which people commonly argue about.
- Note that a positive statement does not have to be a true statement; the statement could be
disproven. It would be false positive statement.
o In other words, positive economics seeks to identify relationships between economic
variables, to quantify and measure these relationships, and to make predictions of what
will happen if a variable changes.
o Conversely, normative statements reflect peoples’ subjective value judgments of what is
good or bad and depend on ethical considerations such as “fairness” rather than strict
economic rationale.

Keep in mind that predictions such as “The Lakers should win the NBA finals this season” or “ Ginebra
San Miguel will win the championship again the PBA season” are not considered normative statements,
but predictions or hopes unrelated to facts or value judgments.

Examples of positive economic statements related to macroeconomics are:


1. The national deficit this past year breached the P280 billion mark.
2. When the value of the dollar falls, the Philippine products imported into the United States
become more expensive.
3. Legalizing drugs will lower the prices of drugs and reduce the crime rate among drug users.

Examples of normative economic statements relative to macroeconomics are:


1. The government should raise taxes and lower government spending to reduce the budget deficit.
2. We need to try to lower the value of the peso in order to discourage the importance of Japanese
goods into this country.
MACROECONOMICS Simplified – Edilberto B. Viray Jr. / Ma. Jesusa Avila – Bato / Lucky Raymundo M. Malveda - 2016

3. Our government should legalize the use of drugs in this country.

CHAPTER SUMMARY
 Macroeconomics is the study of how we can best increase our country’s wealth given the
available resources we have like our land, labor, and capital, and how these resources are
transformed by entrepreneurs into final goods and services which we ultimately consumer to
satisfy our needs and wants.
 The production possibilities frontier represents outcome or production combination that can be
produced with a given amount of resources.
 Economic growth means an increase in national production as measured by the gross domestic
product (GDP) or gross national product (GNP).
 Circular Flow of Model discusses the movement of a simple economy, especially the movement
of goods and services between the two main players of the economy, household (consumer) and
the firms (producer).
 When we refer to nominal values, such as nominal prices, earnings, wages, or interest rates, we
refer to the peso value of the prices, earnings, wages, or the absolute value of the interest rates.
 Real values, on the other hand, are always values in comparison, or relative, to other related
economic variables.
 A normative economic statement is someone’s opinion or value judgment about an economic
issue.
 A positive economic statement does not have to be a true statement, the statement could be
disproven.

DISCUSSION QUESTIONS
1. Why macroeconomics is the biggest branch of economics?
2. Is production possibilities frontier the optimum production of the economy?
3. What’s the different between economic growth and economic development?
4. Can you provide us more examples of positive and normative statement applied in
macroeconomics?