Economics

1. Module 3
Ann mary Jose

2. Economic fluctuations
• Growth is higher in some years than in others; sometimes the
economy loses ground, and growth turns negative.
• These fluctuations in the economy’s output are closely associated
with fluctuations in employment.
• When the economy experiences a period of falling output and rising
unemployment, the economy is said to be in recession
• Economists call these short-run fluctuations in output and
employment the business cycle

5. Business cycle
• Business cycles are economywide fluctuations in total national
output, income and employment usually lasting for a period of 2 to
10 years, marked by widespread expansion and contraction in most
sectors of the economy.
• Two main phases: recession and expansion
• A recession is a recurring period of decline in total output, income
and employment, usually lasting from 6 to 12 months and marked by
contractions in many sectors.
• A recession that is large both in scale and duration is called
depression.

6. • What determines whether a downturn in the economy is sufficiently
severe to be deemed a recession?
• Two major components of GDP— consumption and investment.
• Growth in both of these variables declines during recessions.
• .Investment is far more volatile than consumption over the business
cycle.
• When the economy heads into a recession, households respond to
the fall in their incomes by consuming less, but the decline in
spending on business equipment, structures, new housing, and
inventories is even more substantial

9. AGGREGATE DEMAND AND BUSINESS CYCLES
• Aggregate demand (or AD) is the total or aggregate quantity of output
that is willingly bought at a given level of prices, other things held
constant.
• AD is the desired spending in all product sectors: consumption,
private domestic investment, government purchases of goods and
services, and net exports

10. Shift in AD

12. Business Cycles and Aggregate Demand
• One important source of business fluctuations is shocks to aggregate
demand
• Let us see how a decline in aggregate demand lowers output.
• Say that the economy begins in short-run equilibrium at point B .
• Then, perhaps because of a financial panic or a tax increase, the aggregate
demand curve shifts leftward to AD .
• If there is no change in aggregate supply, the economy will reach a new
equilibrium at point C .
• Note that output declines from Q to Q .
• In addition, prices are now lower than they were at the previous
equilibrium, and the rate of inflation falls.

13. • The case of an economic expansion is just the opposite.
• Suppose that a war leads to a sharp increase in government spending.
• As a result, the AD curve would shift to the right, output and
employment would increase, and prices and infl ation would rise.

15. • Business-cycle fluctuations in output, employment, and prices are
often caused by shifts in aggregate demand.
• These occur as consumers, businesses, or governments change total
spending relative to the economy’s productive capacity.
• When these shifts in aggregate demand lead to sharp business
downturns, the economy suffers recessions or even depressions.
• A sharp upturn in economic activity can lead to inflation.

16. Is the Business Cycle Avoidable?
• Great macroeconomist Arthur Okun, writes,
“Recessions are now generally considered to be fundamentally
preventable, like airplane crashes and unlike hurricanes. But we have
not banished air crashes from the land, and it is not clear that we have
the wisdom or the ability to eliminate recessions. The danger has not
disappeared. The forces that produce recurrent recessions are still in
the wings, merely waiting for their cue”.

17. Economy wont be always in equilibrium!!!
• Inflationary Gap
• If aggregate demand exceeds the aggregate value of output at the full
employment level, there will exist an inflationary gap in the economy.
• AD>AS
• Let us denote aggregate value of output at the full employment by Yf.
• The consequence of such gap is price rise. Prices continue to rise so
long as this gap persists. Inflationary gap thus describes
disequilibrium situation.

19. Inflationary gap
• Let us assume that Yf is the full employment level of national income.
• If C + I + G + (X – M) is the aggregate demand (AD) curve that cuts the 45°
line at point A then an equilibrium income is determinded at Yf.
• There will not be any price rise since aggregate demand equals aggregate
supply.
• Now if the AD curve shifts up to AD’, equilibrium output will not increase
since output cannot be increased beyond the full employment level.
• he vertical distance between the aggregate demand and the 45° line at the
full employment level of national income is termed the inflationary gap. Or
at full employment, there is an excess demand of AB that pulls up prices.

20. • In the inflationary gap, the economy operates at a level over and
above the full employment level.
• The inflationary gap can be eliminated / minimized using
Contractionary Fiscal Policy
• Reducing money income through reduction in government
expenditure, or by increasing taxes.

21. Deflationary Gap
• If the equilibrium level of income is estimated to be below the full
employment level of income then emerges deflationary gap.
• If in the economy there arises insufficient aggregate demand,
equilibrium in the economy will occur to the left of the full
employment income (Yf).
• AD<AS
• In other words, a deflationary gap shows the amount by which
aggregate demand must be increased so that equilibrium level of
income is increased to the full employment level.

23. • The diagram shows that equilibrium level of income is OY* while full
employment output is Yf.
• Thus, the economy faces unemployment situation.
• The distance between the 45° line and the AD line at the full
employment output situation is referred as the deflationary gap. It is
AB in Fig.
• Since aggregate demand is less than the country’s potential output,
the economy suffers from unemployment of labour and other
resources.

24. Expansionary fiscal policy
• The deficiency in aggregate demand thus causes price level to fall.
• This is what happened in the USA, UK, etc., in the 1930s.
• Keynes was arguing at that time that unemployment was the result of
deficiency of aggregate demand.
• He suggested demand management policy (such as, increase in
government spending, reduction in taxes, etc.,) to come out from the
Great Depression of the 1930s

25. Unemployment
• During the recession that began in 2007, the number of unemployed
people in the United States rose by more than 4 million.
• Of the 11 million unemployed people at the end of 2008, half were
“job losers,” people who lost their jobs involuntarily. I

26. • ● Employed. These are people who perform any paid work, as well as
those who have jobs but are absent from work because of illness,
strikes, or vacations.
• ● Unemployed. Persons are classified as unemployed if they do not
have a job, have actively looked for work in the prior 4 weeks, and are
currently available for work
• ● Not in the labor force. the adult population that is keeping house,
retired, too ill to work, or simply not looking for work.
• ● Labor force. This includes all those who are either employed or
unemployed.

27. Unemployment and Okun’s Law
• Unemployment rises in each recession.
• Other labor-market measures tell a similar story.
• For example, job vacancies, as measured by the number of help-
wanted ads that companies have posted, decline during recessions.
Put simply, during an economic downturn, jobs are harder to find.

28. Unemployment and Okun’s Law
• What relationship should we expect to find between unemployment
and real GDP?
• Because employed workers help to produce goods and services and
unemployed workers do not, increases in the unemployment rate
should be associated with decreases in real GDP.
• This negative relationship between unemployment and GDP is called
Okun’s law, after Arthur Okun, the economist who first studied it.
• Okun’s Law states that for every 2 percent that GDP falls relative to
potential GDP, the unemployment rate rises about 1 percentage point

30. Frictional Unemployment
• When people become unemployed voluntarily as they move from job
to job or into and out of the labor force. This is also sometimes called
frictional unemployment because people cannot move
instantaneously between jobs.
• Here are some examples:
• Someone working at the local hamburger stand might decide that the pay is
too low, or the hours are too inconvenient, and quit to look for a better job.
• Others might decide to take time off between school and their first job.
• A new mother might take 3 months of unpaid maternity leave. These workers
have chosen unemployment rather than work in balancing their relative
preferences of income, job characteristics, leisure, and family responsibility

31. Structural unemployment
• Structural unemployment signifies a mismatch between the supply of
and the demand for workers.
• Mismatches can occur because the demand for one kind of labor is
rising while the demand for another kind is falling and markets do not
quickly adjust.
• We often see structural imbalances across occupations or regions as
certain sectors grow while others decline.
• For example, an acute shortage of nurses arose recently as the number of
skilled nurses grew slowly while the demand for nursing care grew rapidly
because of an aging population. Not until nurses’ salaries rose rapidly and the
supply adjusted did the structural shortage of nurses decline

32. Inflation
• Inflation occurs when the general level of prices is rising.
• Today, we calculate inflation by using price indexes—weighted
averages of the prices of thousands of individual products.
• The consumer price index (CPI) measures the cost of a market basket
of consumer goods and services relative to the cost of that bundle
during a particular base year.
• The GDP deflator is the price of all of the different components of
GDP.
• WPI

33. • Deflation occurs when the general level of prices is declining
• Hyperinflation: Hyperinflation is a term to describe rapid, excessive,
and out-of-control general price increases in an economy.

34. • What are the economic forces that cause inflation?
• What is the relationship between unemployment and inflation in the
short run and in the long run?
• How can nations reduce an unacceptably high inflation rate?

35. Expected Inflation
• Inflation has a high degree of inertia in a modern economy.
• People form an expected rate of inflation, and that rate is built into
labor contracts and other agreements.
• The expected rate of inflation tends to persist until a shock causes it
to move up or down.
• The economy is constantly subject to changes in aggregate demand, sharp oil-
and commodity-price changes, poor harvests, movements in the foreign
exchange rate, productivity changes, and countless other economic events
that push inflation away from its expected rate.

36. Demand-Pull Inflation
• One of the major shocks to inflation is a change in aggregate demand
• Demand-pull inflation occurs when aggregate demand rises more
rapidly than the economy’s productive potential, pulling prices up to
equilibrate aggregate supply and demand.
• In effect, demand dollars are competing for the limited supply of
commodities and bid up their prices.
• As unemployment falls and workers become scarce, wages are bid up
and the inflationary process accelerates.

37. • A particularly damaging form of demand-pull inflation occurs when
governments engage in deficit spending and rely on the monetary
printing press to finance their deficits.
• The large deficits and the rapid money growth increase aggregate
demand, which in turn increases the price level.
• Thus, when the German government financed its spending in 1922–
1923 by printing billions and billions of paper marks, which came into
the marketplace in search of bread and fuel, it was no wonder that
the German price level rose a billionfold

40. • Starting from an initial equilibrium at point E, suppose there is an
expansion of spending that pushes the AD curve up and to the right.
• The economy’s equilibrium moves from E to E .
• At this higher level of demand, prices have risen from P to P .
Demand-pull inflation has taken pl

41. Cost-Push Inflation and “Stagflation”
• We see today that inflation sometimes increases because of increases
in costs rather than because of increases in demand.
• This phenomenon is known as cost-push or supply-shock inflation.
• Often, it leads to an economic slowdown and to a syndrome called
“stagflation,”.

42. Example
• Oil prices rose sharply, business costs of production increased, and a
sharp burst of cost-push inflation followed.
• These situations can be seen as an upward shift in the AS curve.
• Equilibrium output falls while prices and inflation rise

44. Phillips curve
• The major macroeconomic tool used to understand inflation is the
Phillips curve.
• This curve shows the relationship between the unemployment rate
and inflation.
• The basic idea is that when output is high and unemployment is low,
wages and prices tend to rise more rapidly.
• This occurs because workers and unions can press more strongly for
wage increases when jobs are plentiful and firms can more easily
raise prices when sales are brisk.
• The converse also holds—high unemployment tends to slow inflation.

45. Short-Run Phillips Curve
• On the diagram’s horizontal axis is the unemployment rate.
• On the left-hand vertical scale is the annual rate of price inflation.
• The right-hand vertical scale shows the rate of money-wage inflation.
• As you move leftward on the Phillips curve by reducing
unemployment, the rate of price and wage increase indicated by the
curve becomes higher
• In the short run, there is a tradeoff between inflation and
unemployment.

47. NAIRU
• .The downward-sloping Phillips curve holds only in the short run.
• In the long run, the Phillips curve is vertical, not downward-sloping.
• This approach implies that in the long-run there is a minimum
unemployment rate that is consistent with steady inflation.
• This is the nonaccelerating inflation rate of unemployment or NAIRU.

48. From Short Run to Long Run
• How does the economy move from the short run to the long run?

49. Period 1
• Period 1. In the first period, unemployment is at the NAIRU. There are
no demand or supply surprises, and the economy is at point A on the
lower short-run Phillips curve ( SRPC )

50. Period 2
• Period 2. Suppose there is an economic expansion which lowers the
unemployment rate.
• As unemployment declines, firms recruit workers more vigorously,
giving larger wage increases than formerly.
• As output approaches capacity, price markups rise. Wages and prices
begin to accelerate.
• In terms of our Phillips curve, the economy moves up and to the left
to point B on its short-run Phillips curve (along SRPC).
• As shown in the figure, inflation expectations have not yet changed,
so the economy stays on the original Phillips curve, on SRPC. The
lower unemployment rate raises inflation during the second period.

51. Period 3
• Period 3. Because inflation has risen, firms and workers are surprised, and
they revise their inflationary expectations. They begin to incorporate the
higher expected inflation into their wage and price decisions. The result is a
shift in the short - run Phillips curve.
• The new short-run Phillips curve lies above the original Phillips curve,
reflecting the higher expected rate of inflation.
• We have drawn the curve so that the new expected inflation rate for period
3 equals the actual inflation rate in period 2.
• If a slowdown in economic activity brings the unemployment rate back to
the NAIRU in period 3, the economy moves to point C.
• Even though the unemployment rate is the same as it was in period 1,
actual inflation will be higher, reflecting the upward shift in the short-run
Phillips curve

52. How can inflation benefit the economy?
• When the economy is not running at capacity, meaning there is unused
labor or resources, inflation theoretically helps increase production. More
dollars translates to more spending, which equates to more aggregated
demand. More demand, in turn, triggers more production to meet that
demand.
• British economist John Maynard Keynes believed that some inflation was
necessary to prevent the Paradox of Thrift. This paradox states that if
consumer prices are allowed to fall consistently because the country is
becoming too productive, consumers learn to hold off their purchases to
wait for a better deal. The net effect of this paradox is to reduce aggregate
demand, leading to less production, layoffs, and a faltering economy.
• Economists once believed an inverse relationship existed between inflation
and unemployment, and that rising unemployment could be fought with
increased inflation. This relationship was defined in the famous Phillips
curve.

53. Tools for stabilization
• Stabilization policy is a strategy enacted by a government or
its central bank that is aimed at maintaining a healthy level of
economic growth and minimal price changes.
• Sustaining a stabilization policy requires monitoring the business cycle
and adjusting fiscal policy and monetary policy as needed to control
abrupt changes in demand or supply.
• Monetary and fiscal policies so as to prevent shocks from turning into
recessions and to keep recessions from snowballing into depressions.

54. Fiscal Policy
• Fiscal policy denotes the use of taxes and government expenditures.
Government expenditures come in two distinct forms.
• First there are government purchases.
• These comprise spending on goods and services—purchases of tanks, construction
of roads, salaries for judges, and so forth.
• In addition, there are government transfer payments, which increase the incomes of
targeted groups such as the elderly or the unemployed.
• The other part of fiscal policy, taxation,
• Taxation affects the overall economy in two ways. To begin with, taxes affect people’s
incomes. By leaving households with more or less disposable or spendable income
• Taxes affect the prices of goods and factors of production and thereby affect
incentives and behavior

55. Monetary Policy
• The second major instrument of macroeconomic policy is monetary policy,
which the government conducts through managing the nation’s money,
credit, and banking system.
• t does so primarily by setting short-run interest-rate targets and through
buying and selling government securities to attain those targets.
• Target the money supply in the economy
• The money supply is the total amount of money(currency+deposit money)
present in an economy at a particular point in time.
• The standard measures to define money usually include currency in circulation and
demand deposits.
• The change in the supply of money in an economy can affect the price level of
securities, inflation, rates of exchange, business policies, etc.

56. Instruments of fiscal policy
• There are two basic components of fiscal policy: government
spending and tax rates (Direct, Indirect tax, Subsidies) .
• Unlike direct taxes that cannot be transferred to another person (for example,
Income tax, Wealth tax), an indirect tax is often levied on goods and services
(Service tax, VAT, etc.) and can be shifted to another person. The tax is
ultimately paid by the end-consumer of the goods and services.

57. Fiscal policy varies in response to changing
economic indicators.
• An expansionary fiscal policy approach is used when the economy
slows down or enters a recession and unemployment rises.
• Under these conditions, policymakers try to stimulate economic activity by
increasing spending, cutting taxes or by doing both. These strategies put more
money into the hands of consumers and businesses
• When there is high employment and strong consumer demand,
prices tend to rise and the rate of inflation can jump.
• When this happens, policymakers may reverse expansionary fiscal policies
(contractionary fiscal policy) and curtail spending or raise taxes. The goal is to
achieve a balance that fosters sustainable economic growth and a strong job
market without excessive inflation or large deficits.
• Contractionary fiscal policy is used when there is an economic peak.

58. It is not always advisable to use fiscal policy during
recessions? Why
• During recessions we use expansionary fiscal policies.
• With less than full employment, a tax cut or government purchase
will produce higher output and lower unemployment, and perhaps
higher inflation.
• As output rises and inflation threatens, central banks may raise
interest rates, discouraging domestic investment.
• Higher interest rates may also cause a country’s foreign exchange rate
to appreciate if the country has a flexible exchange rate; the
appreciation leads to a decline in net exports.
• These financial reactions would tend to choke off or “crowd out”
investment,

59. Crowding out
• Crowding out: The reduction in investment that results when
expansionary fiscal policy raises the interest rate.
• When the government largely spend then it leads to inflation and
which ultimately leads to increase in interest rate. So it will crowd out
the investment of private capital. That in turn will adversely affects
the economy.

60. What could the government or central bank
do to prevent this crowding out?
• When ever government plan to increase spending, with out raising
tax, then this would increase the government deficit and increase
aggregate demand.
• In this situation, the Federal Reserve would need to loosen monetary
policy to prevent the raising interest rate (increase the money
supply).
• Crowding out effect can be prevented by simultaneous mix of
expansionary fiscal policy and expansionary monetary policy.

61. Government Budgets
• Governments use budgets to plan and control their fiscal affairs.
• A budget shows, for a given year, the planned expenditures of
government programs and the expected revenues from tax systems.
• The budget typically contains a list of specific programs (education,
welfare, defense, etc.), as well as tax sources (individual income tax,
social-insurance taxes, etc.).

62. Balanced budget
• A budget surplus occurs when all taxes and other revenues exceed
government expenditures for a year.
• A budget deficit is incurred when expenditures exceed taxes.
• When revenues and expenditures are equal during a given period—a
rare event on the federal level—the government has a balanced
budget

63. Government debt/Public debt
• When the government incurs a budget deficit, it must borrow from
the public to pay its bills.
• To borrow, the government issues bonds, which are IOUs that
promise to pay money in the future.
• The government debt (sometimes called the public debt ) consists of
the total or accumulated borrowings by the government
• When the government taxes (revenue) are less than its expenditure
then the deficit increases

64. Twin deficit
• Twin deficit refers to the situation when an economy suffers from
both the fiscal deficit and the Current Account Deficit.
• Fiscal Deficit - The First Twin
• A fiscal deficit is referred to as a budget shortfall. A current Account Deficit
occurs in an economy when the nation's imports exceed exports. A fiscal
deficit, also called a budget deficit, is a situation which occurs when a nation
is spending more than its revenues
• Current Account Deficit/trade deficit - The Second Twin
• The current account shows a nation's trade and transactions with other
nations. This account includes the difference between the value of goods and
services exported and imported as well as net payments. When a nation's
imports exceed its exports then it is called CAD.

65. Automatic stabilizers (stabilize the economy without additional govt action)
• Automatic stabilizers are a type of fiscal policy designed to offset
fluctuations in a nation's economic activity through their normal operation
without additional, timely authorization by the government or
policymakers.
• Progressive taxation structure ( share of income that is taken in taxes is
higher when incomes are high. )
• The amount then falls when incomes fall due to a recession, job losses, or failing
investments. For example, as an individual taxpayer earns higher wages, their
additional income may be subjected to higher tax rates based on the current tiered
structure. If wages fall, the individual will remain in the lower tax tiers as dictated by
their earned income.
• Unemployment insurance transfer payments
• The amount decline when the economy is in an expansionary phase since there are
fewer unemployed people filing claims. Unemployment payments rise when the
economy is in recession and unemployment is high.

67. Net exports are negative when
• a.Net investment is positive
• b.Exports are exceeded by imports
• c.Imports are exceeded by exports
• d.Exports are exceeded by investments

68. Q1
• Consider an economy in which consumption function is given by
C=600 +0.7 (Y-T), Investment is 250, Government expenditure is 200
and Taxes 150. Estimate equilibrium income and calculate the
expected change in the equilibrium income if an additional tax of 60
is imposed.

69. Q2
• The average propensity to consume (APC) in Macro is approximated
by the equation: APC = (500/Y) + 0.7. Estimate the total consumption
expenditure when disposable income is 2000.
• APC = (500/Y) + 0.8. Estimate the total consumption expenditure
when disposable income is 1000.
• APC = (700/Y) + 0.8. What is autonomous consumption and MPC?

70. Q3
• a) What is the level of autonomous consumption?
• b) Estimate the marginal propensity to consume and marginal
propensity to save .
• c) Due to exogenous factors, the marginal propensity to consume has
gradually changed. The new MPC is estimated to be 0.7. Estimate the
new expected consumption for levels of income mentioned in the
above table.

71. Q4
• a) What is the final output of the economy?
• b) Explain what stage of the business cycle is the economy in?
• c) Explain what fiscal policy measures could the country adopt?
• d) Are there any concerns regarding the policy measures suggested?