Introduction

Written and reviewed by Devendra Dubey, Mathematics & Commerce faculty at UniDrill (M.Sc. Mathematics, Osmania University · 10 years teaching). Based on NCERT Economics Class XII (Introductory Macroeconomics), Chapter 1.

Onions are expensive today. Is that macroeconomics?

Not quite. If onions get costly, you study demand, supply and substitutes, which is microeconomics. But if prices of nearly everything rise together, if factories shut and jobs vanish across the country, the question changes. Now you are asking: will prices as a whole rise or fall? Is employment in the country improving? What would be a reasonable indicator of whether the economy is doing better or worse? What can the State do about it?

These are the questions of macroeconomics. This chapter sets the stage: how macro differs from micro, why it was born in the 1930s, what kind of economy the book studies, and the four sectors you will meet in every later chapter.

Micro and macro: the same economy, a different lens

Microeconomics looks at individual economic agents: consumers choosing the best bundle for their income and tastes, and producers trying to earn the most profit by keeping costs low and selling high. Even a giant company is micro, because it acts for its own shareholders and not for the country as a whole. For micro, big phenomena such as inflation or unemployment are taken as given. No single buyer or seller can change them.

Macroeconomics deals with the aggregate variables of the economy (total output, the general price level, total employment) and with the links between the sectors. It also asks what can be done when the markets alone do not deliver.

An economic agent is any individual or institution that takes economic decisions: consumers, producers, and entities such as the government, corporations and banks.

Why Adam Smith's idea was not enough. Adam Smith, the founding father of modern economics, argued that if buyers and sellers follow their own interest, the wealth of the nation takes care of itself. Economists later found three gaps. In some cases markets do not exist. In others they exist but fail to bring demand and supply into equilibrium. And in a large number of cases society decides to pursue social goals unselfishly, such as employment, education and health, which means the combined effect of private decisions has to be modified. To do that, macroeconomists study taxation and other budgetary policies, and policies on the money supply, the rate of interest, wages, employment and output.

One imaginary good for the whole economy

In practice the output of food grain, industrial goods and services tend to rise and fall together. Prices of different goods also tend to move in the same direction, and so does employment across production units. This allows a great simplification: instead of tracking every product, macroeconomics studies one representative good whose output, price and employment stand for the economy's averages.

The simplification works best when things change fast. In an inflation (prices rising) or a slide towards depression (production and employment falling), nearly all goods move the same way as the aggregate.

It also has a cost. Farm output and factory output are produced under different conditions, and a manager's labour is not the same as an accountant's. So when needed, macroeconomics uses a handful of goods instead of one: agricultural goods, industrial goods and services. Sometimes it also splits the economy into sectors, because the dependence or rivalry between two of them (agriculture and industry, say) explains events better than the aggregate alone.

Why macroeconomics was born in the 1930s

Before 1936, the dominant view was the classical tradition: every worker ready to work finds a job, and every factory runs at full capacity. Then came the Great Depression of 1929. Output and employment in Europe and North America fell steeply, and other countries felt it too. Demand for goods was low, factories lay idle and workers lost jobs. In the USA, between 1929 and 1933 the unemployment rate rose from 3 per cent to 25 per cent, and aggregate output fell by about 33 per cent.

Keynes's break with his predecessors was in the method: he examined the whole economy and how its sectors depend on each other, and he tried to explain unemployment that does not go away on its own.

Beyond the textbook. For the exam: before Keynes the classical tradition held that everyone ready to work finds employment and all factories run at full capacity; the Great Depression overturned that. In reality: classical writers did notice downturns, but they expected them to be temporary, with market forces restoring full employment. Keynes argued that an economy can settle into a stable position with unemployment that lasts. Why it matters: this is the idea behind Chapter 4 of this book, where equilibrium income need not be the full employment income.

Pause and predict: in the Depression, the unemployment rate rose from 3% to 25%. Did unemployment rise by 22%?

Check your answer: no. It rose by 22 percentage points. As a percentage change of the original rate it is (25 − 3) / 3 × 100, about 733%. Mixing the two is a classic slip.

The economy this book studies: capitalism

The book examines a capitalist economy. A typical capitalist enterprise has one or more entrepreneurs, who control the major decisions and bear a large part of the risk. They may supply the capital themselves or borrow it. To produce, they need natural resources (partly consumed, like raw materials, and partly fixed, like plots of land) and human labour. After production, the output is sold, and the money earned is revenue.

Profit is a residual: it is what remains after rent, interest and wages are paid. Part of it is often spent on new machinery or factories next period. Such spending that raises productive capacity is investment expenditure.

A capitalist economy is one in which most economic activity has three features: there is private ownership of the means of production; production takes place for sale in the market; and there is sale and purchase of labour services at a price called the wage rate, so labour is wage labour. In a capitalist country the factors of production earn incomes through the process of production and sale of output in the market.

Beyond the textbook. For the exam: the model assumes a capitalist economy with the three features above, and it may not fully capture a developing country. In reality: almost every economy today is a mixed one, with private firms alongside public enterprises and a large government, and in parts of the developing world family farms using family labour produce mainly for their own use. Why it matters: this is why the book adds the government and the external sector to the picture rather than staying with firms alone.

The four sectors

An economy is seen as four sectors, and the whole book moves around them.

The market in which firms sell could not function without the demand coming from households, and the households' income comes from the firms and the government. That mutual dependence is why the chapters that follow keep going round in circles.

Worked examples

Worked example: micro or macro? Classify each: (a) the price of tea in your market, (b) the general price level of the country, (c) the profit of a large car company, (d) the unemployment rate of India, (e) the RBI changing money supply.

Common wrong step. Calling (c) macro because the company is big. Size does not matter. A giant firm still acts for its own shareholders, so its profit is a micro variable.

Worked example: the unemployment rate. A country has 800 million persons working, 100 million not working but looking for jobs, and 300 million not working and not looking (students, homemakers and others). Find the unemployment rate.

Common wrong step. Counting the 300 million who are not looking and dividing by the whole population of 1,200 million, which gives 8.3%. People who are neither working nor seeking a job are outside the labour force, so they do not enter the rate.

Worked example: the Depression in numbers. In the USA between 1929 and 1933 the unemployment rate rose from 3% to 25% and output fell by about 33%. If output in 1929 was indexed at 100, what is it in 1933, and by how many percentage points did unemployment rise?

Common wrong step. Writing 133 as the 1933 index, or saying the fall in unemployment was "25%". A fall of 33% is subtracted from 100, and rates are compared in percentage points.

Worked example: profit as a residual. A firm earns revenue of ₹2,00,000 in a year. It pays ₹30,000 as rent, ₹20,000 as interest and ₹1,10,000 as wages. Find the entrepreneur's profit.

Common wrong step. Treating profit as a fixed payment like wages. If revenue falls to ₹1,70,000, rent, interest and wages are still ₹1,60,000 and profit drops to ₹10,000. That is why the entrepreneur is the one who bears the risk.

Pause and predict: in the example above, revenue falls to ₹1,50,000. What is the profit?

Check your answer: 1,50,000 − 1,60,000 = −₹10,000, a loss. The other factors were promised their payments, and the entrepreneur absorbs the shortfall.

Worked example: which sector? Name the sectors involved in each transaction: (a) a family buys a mobile phone made in another country, (b) a government school pays its teachers, (c) an Indian firm sells machinery to a foreign firm.

Common wrong step. Calling the school's payment "household spending". Here the government is the spender, and the teachers' household is only the receiver of income.

Exam traps

Formula sheet

60-second revision

Where this chapter connects

The aggregate output you read about here is measured in National Income Accounting. The money supply and the RBI, mentioned as macro decision makers, are the subject of Money and Banking. Keynes's idea that demand can settle below full employment is worked out in Determination of Income and Employment. The government's budgetary policy is in Government Budget and the Economy, and the external sector returns in Open Economy Macroeconomics. For the micro side of the contrast, see Introduction.