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What’s it? The Macroeconomic sector is an aggregate group representing economic actors. Economists divide it into four groups: household, business, government, and external sectors. Each represents an actor in the economy. The expenditures of the four sectors represent the gross domestic product (GDP).
Four types of macroeconomic sectors
In an open economy, the macroeconomic sector consists of four sectors: household, business, government, and external. But, under a closed economy, it comprises three sectors and excludes the external sector. A closed economy does not involve transactions with the foreign sector. Thus, there are no exports and imports.
Household sector
In the goods market, the household sector acts as a buyer. They consume goods produced by the business sector.
Meanwhile, in the factor market, households supply factors such as labor, capital, land, and entrepreneurship. In return, they get income from wages, interest income, profits, and rent. They then use it to buy goods and services or to save money.
In some countries, household consumption is the driver of economic growth. They account for most of the gross domestic product (GDP). Thus, keeping consumption healthy is a goal to promote stable economic growth.
Several factors influence household consumption:
- Disposable income. This is the income left after the household pays taxes. Household consumption increases when their disposable income increases.
- Wealth. The wealth effect plays a role in influencing consumption. Wealth is positively correlated with consumption.
- Expectations of future income and jobs. If households are optimistic about their future income, they will tend to spend money on goods and services. When income and employment prospects deteriorate (such as during a recession), they will save more and reduce consumption of less essential goods.
- Interest rate. Households rely on loans to purchase items such as cars, houses, and other durable items. When interest rates fall, they are incentivized to apply for new loans and buy those items.
Business sector
The business sector represents the producers of goods and services in the economy. It may include proprietorships, partnerships, and corporations. To produce goods and services, businesses buy inputs in factor markets. Then, they sell output in the goods market to earn income.
Business sector investment spending represents the most volatile component of GDP. Its change usually causes economic growth to tend to fluctuate in the short term.
Meanwhile, in the long run, business investment is essential for increasing potential output. When the net investment is positive (actual investment is more significant than the depreciation of fixed assets), the physical capital stock increases. It increases the productive capacity and potential GDP, thus enabling the economy to produce greater output in the future.
Some factors influence production and business investment:
- Input prices. For example, a reduction in raw material prices lowers production costs, encouraging businesses to increase production.
- Business confidence. Suppose businesses feel confident about future demand and profits. In that case, they are likely to invest in capital goods to increase production capacity.
- Expected future selling price. When companies expect future selling prices to increase, they will increase production to anticipate higher profit margins. The opposite effect also applies when future prices tend to fall, for example, due to a prolonged recession.
- Tax. Taxes reduce corporate profits and disincentive companies to increase production and investment.
- Production subsidies. An increase in subsidies lowers production costs, encouraging businesses to increase production.
- Capacity utilization. Suppose the utilization rate has approached full capacity. In that case, the business will need to increase investment spending to continue growing and anticipate higher demand in the future.
- Interest rate. Companies often rely on external financing, such as issuing debt securities. Thus, when interest rates are low, they reduce the cost of capital and encourage investment.
Government sector
The government provides public services and regulates several economic activities. It collects taxes from the business and household sectors to finance expenses. If tax revenue exceeds spending, the government runs a fiscal surplus. If expenditures exceed revenue, the government operates a fiscal deficit.
Governments influence the economy by changing their spending and taxes. They increase spending or reduce taxes to stimulate economic growth, or they reduce spending or raise taxes to avoid an overheated economy.
The central bank is part of the government sector. In some countries, the central bank may operate under government supervision. Meanwhile, in other countries, such as Indonesia, they operate independently, although they remain under the law.
In general, government spending falls into the following three categories:
- Routine spending. This includes spending on goods and services for day-to-day operations. Examples are staff salaries, government office supplies, health, education, and defense.
- Capital expenditure. This component covers spending on infrastructure, which contributes to the capital stock in the economy.
- Transfer payments. This consists of payments to other sectors without involving the exchange of goods and services. Examples of transfer payments are unemployment benefits, income allowances for poor families, and other social programs.
Unlike household consumption and business investment, some government spending depends on discretionary policies. It does not depend on economic ups and downs but on government decisions.
Meanwhile, some components, such as transfer payments, are counter-cyclical. They rise during recessions and fall during economic expansion.
Furthermore, apart from the budget, the government also influences economic activity and the three other sectors through regulations and policies. Price controls, competition regulations, labor, and environmental safety are some examples.
External sector
The external sector represents economic actors abroad. It also comprises the household, business, and government sectors. Still, it is outside a country’s territory.
This sector interacts with the domestic economy through foreign trade and capital flows. Exports represent the external sector’s demand for domestic goods and services. Meanwhile, imports represent domestic demand for goods and services produced by the external sector.
In international trade, the exchange involves goods and services and involves currency to facilitate payment. Thus, external sector trade impacts the demand for goods (economic growth) and impacts the domestic currency exchange rate.
Furthermore, interactions with the external sector also involve capital flow, either by citizens or foreigners. When foreigners invest in the country, it can take two forms: foreign portfolio investment and foreign direct investment. Foreign portfolio investment is usually shorter-term than direct investment.
In general, activity with the external sector depends on the following factors:
- Domestic vs. international economic growth prospects
- Domestic vs. international interest rates spread
- Domestic inflation rate vs. inflation abroad
- Domestic exchange rates with partner countries
- Trade barriers and capital flow control
- Investment climate and ease of doing business
- Government policies, whether related to economy, business, or politics (regulation)
The Interconnected Economy
The four macroeconomic sectors we’ve explored – households, businesses, government, and the external sector – don’t operate in isolation. They are intricately linked, and decisions made in one sector can have ripple effects throughout the entire economy.
- Household spending drives business production: When households feel confident and have disposable income, they spend more on goods and services. This increased demand encourages businesses to produce more to meet consumer needs.
- Business investment impacts household income: Businesses invest in new equipment and facilities to expand production. These investments often create new jobs and increase wages, boosting household income and potentially leading to even higher spending.
- Government policy affects all sectors: The government can influence economic activity through spending and taxation. Increased government spending can stimulate demand for goods and services, benefitting businesses and potentially leading to higher employment for households. Conversely, tax increases can reduce disposable income, dampening household spending and potentially impacting business production.
- The external sector influences domestic activity: Exports from domestic businesses create demand abroad, leading to increased production and potentially more jobs. Imports, on the other hand, can satisfy domestic demand for goods and services at a lower cost but may also compete with domestic producers. International trade and investment flows can also impact exchange rates and the overall cost of goods for households and businesses.
In short, the decisions of consumers, businesses, governments, and foreign entities constantly interact and shape the overall health of the economy. Understanding these interconnected relationships is crucial for policymakers and businesses alike to make informed decisions that can promote sustainable economic growth and prosperity.
