Introduction to Macroeconomics

Macroeconomics refers to the study of the behavior of the economy as a whole.

The overall objective of a macroeconomic policy is to raise the average standard of

living in a given country

Objectives of macroeconomics

i) Full employment: This is a situation whereby all resources available are

fully utilized. There are no idle resources.

ii) The Control of inflation: Inflation refers to a persistent rise in the

general price level. An excessive rate of inflation can have a number of

adverse effects on the economy.

iii) Economic growth: This refers to a sustained increase in the productive

capacity of a country. This in turn leads to an increase in the quantity of

goods and services available in a country.

iv) External balance: this objective aims at getting the balance of payments

in equilibrium by avoiding persistent deficits and surpluses.

1
NATIONAL INCOME

National income is a measure of the total monetary value of the flow of final goods

and services arising from the productive activities of a nation in any one year.

Concepts of National Income

i. Gross Domestic Product (GDP): Total monetary value of all final goods

and services produced within the geographical boundaries of a country. The

term 'gross' implies that no deduction for the value of the expenditure goods

for replacement purposes (depreciation) is made. Since the income arising

from the investments and possessions owned abroad is not included, only the

value of the flow of goods and services produced in the country is estimated.

Hence the word 'domestic' is used to distinguish it from Gross National

Product. The output considered in this case is that produced by all

individuals in a country, irrespective of their citizenship.

ii. Gross National Product (GNP): Total monetary value of all goods and

services produced by the nationals or citizens of a given country. Some of

this output may be produced by nationals engaged in productive activities

abroad.

GNP = GDP + Net factor income from abroad.

2
Net factor income from abroad refers to the difference between the incomes

accruing to domestic residents arising from productive activities abroad less

income earned within the domestic economy accruing to non-residents. This

distinction accruing to non-residents. This distinction arises because domestic

production may be carried out with the assistance of inputs belonging to the

residents-of other countries while it is also possible for the residents of a given

country to be engaged in productive activities abroad

The difference between GDP and GNP will be greatest in those countries which

allow a high level of foreign investment but do not invest heavily themselves. This

is the case of many developing countries where multinational corporations have

invested heavily. These developing countries have, however, not invested

considerably abroad themselves. Thus their estimated GDP is usually greater than

their GNP.

iii. Net National Product(NNP) at market price

NNP = GNP – DEPRECIATION ALLOWANCE

The concept of Net National Product provides for capital consumption. Capital

consumption is the replacement value of capital used in the process of production.

Capital consumption or depreciation recognizes the reduction in the value of assets

3
which generally arises from wear and tear. NNP at factor cost is, however, the

actual national income.

iv. NNP at factor cost

NNP at factor cost = N.N.P. (at market price) - indirect taxes + subsidies.

In measuring Net National Product, market prices are initially used to value

outputs so that they can be aggregated. This implies that to the extent that market

prices include indirect taxes and subsidies, the value of the output will not equal

the value of the incomes paid out to factors of production. This arises because it is

the revenue received by firms after indirect taxes which is distributed as factor

incomes. Therefore indirect taxes are deducted while subsidies are added. The Net

National Product at factor cost is consistent with the value of incomes paid to the

factors of production.

NB: NNP at factor cost is the actual national income.

v. National disposable income

National Disposable Income = national income + (-) net transfer receipts or

payments.

This concept becomes useful where a country receives substantial transfers from

abroad either to the government or to individual residents, or alternatively where

4
the residents of a given country send out substantial remittances. The concept of

National Disposable Income, therefore, measures the aggregate resources available

to a nation for saving or consumption.

vi. Nominal versus real national income

National income is concerned with changes in the volume of output. But to obtain

uniformity, national income is measured in money value. However, a change in

money value can occur because of a change in either quantity or price. Thus money

value can change while leaving the volume of goods and services constant. So an

inflation deduction known as 'Stock Appropriation' has to be carried out.

Real national output, therefore, refers to the value of total

output measured in 'constant prices' (measured in the prices

of a base year). This implies that the general rate of inflation is

deducted so as to record the real command over resources.

Nominal national output describes the measurement of total

output in current prices. Price indices are used to convert

nominal values', whose measurement is in the current year

prices, to real values by keeping prices at a selected base year

level.

vii. Per capita income

5
Per capita income is the national income divided by the total population of the

country. It represents the average income of the people in a given year (income per

Head).

Per capita income = national income

Total population

Uses of national income statistics

National income statistics may be useful in the following ways:

1. To indicate the standard of living

Standard of living refers to a measure of people's living conditions, measured by

their material wellbeing.

3. To assess the rate at which a nation's income is growing

Growth is a major government objective and so it is essential to be able to measure

it.

Economic growth is the increase in a country's productive capacity, identifiable

by a sustained increase in real national income over a period of time.

Economic development, on the other hand, is associated with a rise in real

national income and is also accompanied by major structural changes in the

economy, such as a shift from agriculture to manufacturing.

6
4. To assist the government in planning the economy

National income statistics play a role in the planning of both short and long run

government policies. They show trends in consumption and investments, changes

in employment, inflation and economic growth due to changes in national income.

They enable the government to assess what policy measures to take to correct

adverse trends such as low investment. They are useful in preparing the budget so

as to determine expenditure in appropriate sectors and formulate sectorial policies.

5. To forecast future trends

National income statistics may be used to forecast future performance. Proposed

changes in the budget, for instance, will be compared against the likely outcome.

On the basis of these statistics the future-strategy is planned. National income

statistics can help to better understand the manner and pattern of economic activity,

and to provide an empirical data base upon which economic models are built.

Forecasts can assist institutions financing different sectors.

5. Business community

The business community can use some of the data provided by •national income

statistics to understand market trends so as to invest appropriately. For example,

national income sectorial data can assist in showing which sectors are growing and

which are declining.

7
Limitations of using national income statistics to indicate the standard of

living

i. Other forms of wealth: National income statistics consider the flow of

wealth created by production, around the economy. But a substantial

proportion of wealth does not flow, for example, property and houses, rare

paintings, stocks and shares. Thus national income statistics do not take

account of the well-being gained from, for example, owning a valuable

painting or other non-economically measurable benefits that contribute to

our welfare such as leisure time, long holidays, job satisfaction, health, good

friends, and pleasant surroundings.

ii. Inflation:

A rise of GNP in money terms, may be accompanied by a fall in real terms

(in terms of how many goods and services we are receiving) because

statistics are recorded in money terms while the value of money itself can

change. Inflation may therefore distort national income estimates. In

measuring standards of living we are interested in how many goods and

services we will receive and not in receiving more money that will buy less.

iii. Population
8
 The measurement of the total value of goods and services produced in a year

is itself insufficient to make conclusions about standards of living. Countries

may have similar levies of GDP but considerably different levels of GDP per

head. In addition, a country may have a rising GDP per head, not because

the real output is rising, but due to a population decline.

iv. Distribution of income

The use of income per capita as a measure of living standards presupposes

that all people are receiving the same proportion of the national cake.

Despite taxation and welfare distribution, the highest income is normally

concentrated in the hands of about 1% of the total population. So an increase

in national income may be distributed among a small proportion of the

population.

v. Producer versus consumer goods

An increase in national income brought about by an increase in the

production of production goods on investment does not increase present

welfare. The investment for national income statistics is usually passed on

factor costs, although it is viewed in terms of future production it can often

be seen as far more valuable than present consumption.

vi. Working hours: (Income in relation to effort)

9
 An increase in national income may be the result of longer working hours

and inferior working conditions perhaps also accompanied by longer

journeys to work.

vii. Government expenditure:

Since government expenditure is included at cost in national income

statistics, no distinction is made between various types of expenditure. If

defence expenditure is ten times more than that of building new houses, can

we claim that defence expenditure improves our welfare 10 times more than

housing? Social services could be curtailed to finance a rearmament

programed, yet national income would remain unchanged.

viii. Social costs and benefits

National income figures are based on private costs and benefits. Social costs

or benefits do not enter the calculations. Thus, for example, increased

mineral production may be achieved at the expense of degrading the

landscape or increasing the levels of pollution. A true picture of national

income should thus ideally incorporate these 'hidden' costs and benefits.

ix. Previously performed services:

National income is swollen when people pay for services they previously

performed, although there may be no net increase in production in terms of

services performed.
10
x. The level of accuracy

The level of accuracy of estimated data between the time periods being

compared is usually different. Thus estimates of the value of the subsistence

section. Population estimates, and estimates of depreciation are rarely

accurate. Inaccuracy of data may lead to wrong conclusions being dawn

about standards of living.

xi. Change of the level of unemployment over time

Generally the level of unemployment is inversely related to standards of

living. Levels of unemployment are not taken into account in using per

capita income and it is difficult to reconcile changes in the rate of

unemployment to determine the net effect on the standard of living.

Limitations of using national income statistics to compare the standards of

living in different countries

National income statistics are often used to compare the standards of living in

different countries. GDP statistics also form the basis of major international

contributions and receipts. GDP forms the basis on which the IMF quotas are

fixed, and through that the members' voting power, the amount of foreign

exchange that can be drawn from the IMF and the allocation of Special Drawing

Rights (SDKs).
11
Limitations of using national income statistics to compare standards of living

in different countries

i. Different currencies

Since figures are expressed in different currencies, they need to be converted into a

common denominator. It is difficult to convert all the figures into one currency

valuation.

ii. Different definitions

The goods and services included in the definition of national income differ from

country to country. Thus, for example, the former Eastern European countries

excluded the value of non-material services such as public administration, and they

also included defence and personal and private services. When comparisons are

made, account must be taken of these different definitions to avoid rendering them

meaningless. The subsistence sector constitutes a considerable proportion of the

economy in developing countries. Although developed countries such as the

United Kingdom exclude the subsistence sector, for developing countries to do this

would significantly undervalue both their national product and their standards of

living. The problem here is one of the product boundary. In addition, goods

considered illegal in some countries may not be so in others.

iii. Distribution of income

12
Although income per capita may be similar, standards of living may differ

considerably because of differences in income distribution. A country may have a

high average income per head which is earned by a minority while the majority of

the population is poor. This is the case, for example, in some of the oil -producing

states of the Middle East.

iv. Different needs and tastes

In using per capita income as measure of the standard of living, the standard of

living of one country should not be compared to or assessed in terms of what

another country finds valuable For example, the fact that people in northern

countries spend more money on heating does not make their better off. This

implies that before a comparison can be made, we must be certain we are

measuring things that mean the same dung 10 different people.

v. Differing price structures

Since price levels deficit considerably between countries, a random selection will

be priced differently. Thus, an apparently higher standard of living as reflected by

national income may be distorted by differing or higher price levels.

vi. Income in relation to effort

An increase in national income may be the result of longer working hours, inferior

working conditions or longer journeys to work. Thus an increase in income may be

accompanied by a decline in the standard of living. Also a decline in income may

13
occur because of increased leisure, although the decreased working hours may

compensate for this decline in income to some extent.

vii. Differing levels of unemployment

Differing levels of employment make comparisons harder since they make it hard

to calculate the net effect on standards of living.

METHODS OF MEASURING NATIONAL INCOME

We now consider the methods, of measurement of national income, outlining the

major adjustments that have to be made so that the statistics are accurately

recorded and the estimates by different methods are equivalent. Each time a

commodity is produced and sold we can say that:

i. The value of the commodity is equal to the purchaser’s expenditure on it.

ii. The same sum of money will be received as income by the different

individuals who contributed to the production at some stage.

iii. The value of the commodity sold will have resulted from the value added to

it by successive stages of production.

The above implies the total monetary value of goods and services produced

and sold during a particular year can in theory be calculated by

i. Adding together market expenditures by final consumers.

14
 ii. Adding the income received by different factors of production which have

contributed to the production.

iii. Determining the value of each firm's contribution to output or its "value

added".

These alternative measures provide a basis for the expenditure, income and output

methods which are really three ways of arriving at the same total.

METHODS OF MEASURING NATIONAL INCOME

1. Income method

The income approach takes national income as the sum of all incomes earned by

factors of production in the economy: included are personal incomes which have

been earned for services rendered and in respect of which there has been some

corresponding value of output, income as benefits such as rent-free housing should

be imputed as income from employment both in private and public sectors, the

gross trading profits of companies and gross trading surpluses of public

corporations and the government, imputed rent (rent broadly taken to include

income from land or property such as housing; and income from subsistence

production..

Net property income from abroad is a standard adjustment for all the three methods

of measurement.

Adjustments
15
i. Transfer payments are deducted otherwise double-counting would occur.

Examples of transfer payments are pensions and social security payments.

Transfer payments merely represent a redistribution of income taxpayer’s

money to the transfer recipients.

ii. Stock appreciation is deducted since it has already been adjusted in output

figures. Stock appreciation is the increase in the value of stock resulting

from an increase in market prices.

iii. Residual error: Errors resulting from collection of data. This correcting

item is added on to, or taken away from the output and income totals to

correct them to the expenditure totals.

iv. Net factor income from abroad.- the difference between the incomes

accruing to domestic residents arising from productive activities abroad less

income earned within the domestic economy accruing to non-residents.

v. Capital consumption or depreciation. This is deducted since-new

machines and tools have been produced to replace worn out and obsolete

equipment.

Problems associated with the income approach of measuring national income

i. Transfer payments have to be deducted since they constitute income for

which no goods or services have been produced (this implies that there is no

net increase in income). A problem arises since it "is difficult to impute the
16
 proportion of income constituted by these transfers, and especially difficult

when transfers took place and no record was made of them since inclusion

leads to double counting.

ii. The problem of availability and accuracy of data on income-earned,

especially profits of private firms, which may want to evade tax It is also

difficult to obtain figures for net factor income from abroad.

iii. Imputing income of the large subsistence sector in developing countries is

very difficult given seasonal and regional price fluctuations. In addition

production or output values for the subsistence sector in developing

countries are very difficult to determine.

iv. There is a problem of handling illegal activities which yield an income to the

recipient.

2) Product or Value Added Approach:

This constitutes the most direct approach, Using this approach, national income is

found by adding up the value of all final goods and services produced by firms

during the year. National income is assumed to be the total of the value added to

output by all enterprises in economy. The total or value added by different stages

of production equals the final value of output of a final good.

17
 It measures the value which a firm has 'added' to the raw materials and

components by its processes of production. The value-added method totals the

value added at each stage of production and then obtains the total value of all final

products.

Adjustments:

i. Adjustment for financial services, such as insurance and banking include

the interest paid to the firms lending money. Unfortunately, this interest on

borrowed money is also recorded as a cost in the firms that borrowed it. It is

therefore counted twice.

ii. Stock appreciation: National income statisticians are interested in the

actual production added during the year, so an increase in value of stocks

due to rising prices is subtracted.

iii. Residual error.

iv. Net factor income from abroad.

v. Depreciation.

Problems associated with the product approach of measuring national

income.-

i. The problem of the product boundary which relates to the problem of

what goods and services to include, for example whether to include

housewives services and other sell-employment output values.

18
 ii. Problem of valuation due to unavailability and lack of accuracy of output

figures especially in the private sector.

iii. Valuation of the subsistence sector because of inaccurate statistics of

volume of production and decisions on what prices to use give seasonal

and regional price variations.

iv. Difficulty in distinguishing primary inputs from intermediate inputs.

v. Problem of valuation in the use of different sectional rates of inflation.

vi. Problem-of valuing government output, for example, education, since it

is not sold on the market. The solution of valuing, government output at

factor cost is also unsatisfactory since a rise in factor cost may not be

accompanied by an increase in output. For example, a rise in teachers’

salaries seems to reflect a rise in the output of the education industry.

vii. The problem of valuing illegal activities which might have entered into

the production process for example the drug trade.

3) Expenditure Method

This approach arrives at National income by adding together expenditure on all

final goods and services in the economy. Total expenditure is broken into 5 broad

categories: Consumer expenditure(C), Government spending(G), private

investment expenditure(I), imports(M) and exports(X). This can be represented by

the following identity:

19
 Expenditure= C + G + 1 + X - M

Adjustments

i. Imports: Under both the output and income methods, imports are excluded.

Imports must therefore be excluded under this method because they do not

generate income domestically.

ii. Exports: Exports are included because they may create income

domestically.

iii. Taxes are not a payment (or anything produced and has therefore not been

recorded as production on the output method, nor as factor incomes. Subtract

taxes

iv. Subsidies: These make the final product appeal less valuable than it really if-

and hence they are added.

v. Net factor income from abroad,

vi. Less capital consumption.

vii. Less the value of physical increase in stocks and work in progress.

Problems associated with the expenditure approach of measuring national

income

i) No accurate records of expenditure values are kept especially in the private

sector.

20
ii) Imputing the value of spending of the subsistence sector on its output is

difficult.

iii) The problem of distinguishing between expenditure on final and intermediate

goods.

iv) Double-counting: This may arise, for example, from government expenditure

on students' allowances, bursaries, interest on public debt, second-hand goods,

financial assets neither of which involve fresh output.

v) The problem of valuation of imports and exports in an economy with

fluctuating exchange rates.

21
 CIRCULAR FLOW OF INCOME AND EXPENDITURE

This is a simple model of the workings of an economy depicting the movements of

resources between producers and consumers. A number of monetary flows

comprise the circular flow of income:

i. Wages and salaries paid by firms to households.

ii. Money spent by households and received by firms.

Corresponding to these flows is a flow of some real resource in return:

iii. Labour is provided by households to firms.

iv. Goods and services are provided by firms for households.

Diagram: Circular flow of income and expenditure

22
There are therefore, a total of four flows and a complete symmetry between the

two sectors of households and firms. Each provides the other with some real

resources and each receives cash in return. In addition, each spends that cash on

the supply of the other. The same cash is spent by one sector and then the other

continuously. National income can be measured by either of the two cash flows,

total wages and salaries comprise the income measure, while the total household

spending comprises the expenditure measure. These two are different sides of the

same coin and. in an economy where all income is spent domestically, will

necessarily be equal to each other.

In the case of subsistence production, households are at the same time the

producing and consuming units. They can be regarded from the expenditure point

of view as spending on then own output and from the income point of view as

receiving income themselves.

In reality, there are leakages/withdrawals from the circular flow:

1) Savings (when money is received from households but not spent)

2) Imports (when money flows to foreign firms)

3) Taxation (when money flows to the government).

Each of these 'withdrawals.', however, gives rise to a corresponding injection':

1) Investment

2) Exports
23
3) Government spending

If all components are in equilibrium, each pair will balance exactly

General criticisms of national income statistics

i. Inadequate information: Under all methods of measurement there is

problem of inadequate information. Some of the information is arrived at

only through estimation.

ii. Not all production is included: Some production like housewives

services' is excluded because of the- difficulty of measurement although it

adds to the total wealth.

iii. The black or illegal economy: A considerable amount of production is

simply not included since transactions are not recorded because buyers and

sellers are purposely hiding the transactions. The legalization of formerly

illegal products would have a profound effect on national income statistics,

yet this production has been going on all the time.

iv. Depreciation: Depreciation is based on the forecast life of fixed capital.

However, this forecast life is only an estimate. The capital, say a welding

machine may be obsolete In 3 years of may still be working after 15 years.

Depreciation may also be calculated according to different methods and the

24
 method of calculation has considerable implications for national income

statistics.

v. Economic 'goods' and 'bad' People may be working and be paid an Income

yet they may not really be producing anything. There's a wide range of

products that appear to improve the standard of living, but frequently have

other unrecorded effects such as health problems. Facilities may have to be

diverted away from other uses, thus lowering the general standards of living

in comparison to a situation where, say nobody smoked, National income

statistics do not carry out a cost-benefit analysis where, for example,

production is related to environmental improvement.

25
THE CONCEPT OF EQUILIBRIUM INCOME

The equilibrium level of national income is that level of national income which

exhibits no tendency to change. Equilibrium can be viewed as existing when the

aggregate demand for the economy's goods and services is just equal to the total

value of the goods and services produced.

Aggregate demand consist of households' consumption(C), private sector

investment (I), government spending (G), exports(X) minus imports (M)

AD = C + 1 + G + (X - M)

The total value of goods and services is measured by the national income.

The income(Y) received is spent on Consumption(C), savings(S) and taxes(T)

I.e

Y=C+S+T

The equilibrium condition is;

Aggregate demand = National income

C + 1 + G + X- M = C + S+T

This in turn implies that:

1+G+X=S+T+M

Injections=Withdrawals

Investment, government spending and exports are known as injections into the

flow of national income while savings, taxes and imports are called withdrawals
26
from that flow. Injections refer to an exogenous addition to the income of firms or

households. Injections exert an expansionary pressure on the level of national

income; Withdrawals or leakages refer to any income that is not passed on in the

circular flow of income and is therefore not available for spending on currently

produced commodities. Withdrawals exert a contractionary pressure on the level of

national income.

Keynesian Income-Expenditure Model

In the simple Keynesian income-expenditure model the equilibrium level of

national income can then be considered as that level of national income where

injections equal the level of withdrawals. This is where:

I + G + X = S + T+ M

Injections (J) =Withdrawals (W)

- It is not necessary for each withdrawal to equal its respective injection, only that

the value of all injections equals the value of all withdrawals. It follows that if

there is any disturbance in the equilibrium the necessary condition for return to

equilibrium is that the change in injection equals the change in withdrawals.

27
DIAGRAM: Using a graph to determine equilibrium national income

equilibrium(in an open economy)

A MATHEMATICAL APPROACH TO NATIONAL INCOME

EQUILIBRIUM

The simple Keynesian model of national income can be represented in the

following way:

Y =C + Io + Go........................................... (10.1)

Where:

C = Consumption expenditure

I0 = Investment expenditure

Go = Government expenditure

The equation (10.1) implies that national income equals total expenditure.

28
A functional relationship can further be developed between

consumption (C) and the national income which is given by:

C = a + By ………This is referred to as the Consumption function

In the above function a does not depend on the level of national income and is

therefore referred to as autonomous consumption. The component bY of the

function, on the other hand, depends on the level of income and is known as

induced consumption. Since the consumption function has a positive slope, this

implies that as the level national income increases so does the consumption

expenditure.

The slope coefficient b is referred to as the marginal propensity to consume

The marginal propensity to consume is the change in consumption that arises from

an additional unit of income.

It can be expressed as follows:

MPC = C ; Where C is consumption and Y is income

In the model represented by equation (10.1) income (Y) and consumption (C) are

assumed to be endogenous. Investment (lo) and government expenditure (G 0) are

assumed to be exogenously determined.

29
An endogenous variable is one whose value is determined within a set of

equations, or models. An exogenous variable is one whose value is not determined

within a set of equations or models.

The equation Y = C + lo + Go represents an equilibrium condition.

The equilibrium national income (Y) and consumption (C) can be determined in

terms of the parameters a and b.

Y = a + bY + Io + Go

Y - bY = a + Io + Go

(1-b)Y = a + Io + Go

= a + Io + Go

1-b

If Y substitute this value for Y into equation (10.2) we can obtain the equilibrium

value for consumption.

Example;

In a given country; a = 270, b = 0.8, IO = 150 and Go = 60

Calculate;

1) Equilibrium level of national income.

2) Consumption

30
Answer

The above model refers to a closed economy with no taxes. This framework can

be extended to include the foreign sector such that:

Y= C + 1 + G + (X – M)

Where:

C = a + bY

And M = m + mY

Imports (M) are made up of two components:

i. MO which represents autonomous imports. Autonomous imports do not

depend on the level of national income.

ii. mY which represents induced imports that depend on the level of national

income.

31
The coefficient m is referred to as the marginal propensity to import. The

marginal propensity to import (MPM) refers to a change in imports as a result of a

unit change in income. It may be expressed as follows:

MPM = M

Example

Taking a Simple numerical example where: 1o = I80. Go = 130,X0 = 80, a = 40, m0 =140, b =

0.9 and m = 0.15

Calculate;

1) Equilibrium level of national income.

2) Consumption

Answer

INFLATIONARY AND DEFLATIONARY GAPS

32
INFLATIONARY GAP

An inflationary gap is said to exist when the aggregate expenditure exceeds the

maximum attainable level of output with the result that there is an upward pressure

on prices.

DIAGRAM

Yf represents the full-employment level of income of the level of income or the

level of income where resources achieve the maximum attainable level of output.

Ye represents the equilibrium level of national income which is greater than the

full employment level of income. As a result there is an inflationary gap with that

associated upward pressure on prices.

Appropriate fiscal policies to combat tins demand-pull inflation would be a

33
reduction in government spending or an increase in taxation with the objective

being Toto reduce aggregate demand by the full amount of the inflationary gap.

Deflationary Gap

A deflationary gap refers to a situation where the aggregate expenditure falls short

of that required to produce a level of national income that would ensure full

employment. This is shown in the income-expenditure model by an aggregate

expenditure function which cuts the 45 degree line at less than the full employment

level of national income. A deflationary gap can be treated by an increase of

government spending or a reduction in taxes.

DIAGRAM

TRADE CYCLES

34
Cyclical fluctuation in the level of economic activity can be observed through the

examination of annual changes in real national income over a number of years. The

phases of the trade cycle can be illustrated below.

DIAGRAM;

1) Slump or depression;

-There is generally a high level of demand-deficient unemployment of labour and

capital.

- A low level of both consumption and investment leads firms to cut back on their

production, lay off workers and leave capital equipment lying idle.

-Despite the availability of money for firms to borrow and low interest rates,

investment may not be forthcoming because of pessimistic expectations.

35
2) Recovery/Revival phase

-The level of aggregate demand is rising

-Businessmen are more optimistic.

- Rising investments demand

- expanding output levels

-declining rate of unemployment eventually

3) Peak/Boom

- There is low unemployment

-a high level of demand

-firms working at full capacity

- High profits.

4) Recession/ deflation phase

-the demands of both firms and households begin to fall

- Firms profit fall

- output and employment levels fall as businessmen once again become pessimistic

about the future level of demand for their product and extremely reluctant to invest

in new capital.

36
Eventually the slump is reached and the whole process starts again.

37