Macro unit 1

Macroeconomics
• Macroeconomics deals with issues related to data that
give summary descriptions of the economy of an entire
nation.
• It is that part of economic theory which studies the
economy in its totality or as a whole. Macroeconomics is
the study of aggregates and averages of the entire
economy.
• Such aggregates are national income, total employment,
aggregate savings and investment, aggregate demand,
aggregate supply general price level, etc.

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Introduction to Macroeconomics
• Microeconomists generally conclude
that markets work well.
Macroeconomists, however, observe
that some important prices often
seem “sticky.”
• Sticky prices are prices that do not
always adjust rapidly to maintain the
equality between quantity supplied
and quantity demanded.

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Macroeconomic Concerns
• Three of the major concerns of
macroeconomics are:
– Inflation
– Output growth
– Unemployment

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The Roots of Macroeconomics
• In 1936, John Maynard Keynes published The General Theory
of Employment, Interest, and Money.
• Keynes believed governments could intervene in the economy
and affect the level of output and employment.
• During periods of low private demand, the government can
stimulate aggregate demand to lift the economy out of
recession.

Macroeconomics Analysis: An Overview 6
Development of Macroeconomics: School
of Thought
• Before Keynes came up with his theory in 1936, there was
essentially only one economic theory – the classical
theory.
• Keynesian Theory was very successful in explaining the
causes for large-scale unemployment in the 1930s.
• There has been another extension of the classical theory
in 1950s known as Monetarism.
• In the 1970s came a new theoretical development with
foundations in classical theory i.e. the concept of rational
expectations.

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Government in the Macroeconomy
• There are three kinds of policy that
the government has used to
influence the macroeconomy:
1. Fiscal policy
2. Monetary policy
3. Growth or supply-side policies

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Government in the Macroeconomy
• Fiscal policy refers to government policies
concerning taxes and spending.
• Monetary policy consists of tools used by the
Federal Reserve to control the quantity of
money in the economy.
• Growth policies are government policies that
focus on stimulating aggregate supply instead
of aggregate demand.

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Inflation and Deflation
• Inflation is an increase in the overall price level.
• Hyperinflation is a period of very rapid increases
in the overall price level. Hyperinflations are
rare, but have been used to study the costs and
consequences of even moderate inflation.
• Deflation is a decrease in the overall price level.
Prolonged periods of deflation can be just as
damaging for the economy as sustained inflation.

Basic Concepts
• Stock and Flows
• Equilibrium and Disequilibrium
• Static and Dynamic
• National Product and Domestic Product
• Aggregate Consumption
• Gross Domestic Savings
• Gross Domestic Capital Formation
• Industrial Production and Agricultural Production
• Wholesale Prices, Consumer Prices and Inflation
• Employment

Basic Concepts
• Balance of Payment (BoP)
– Components of BoP:
• The Current Account
• The Capital Account
• The Official Reserve Account
• Rate of Growth
• Money Supply and Monetary Policy
• Government Finances and Fiscal Policy
• Business Cycles

An Introduction to Economic Analysis 12
Interdependence of Macroeconomics and
Microeconomics
• In microeconomics, the underlying assumptions
is that the total output, total employment and
total spending are given.
• What macroeconomics take as given- the
distribution of output, employment and total
spending which microeconomics seeks to explain.
• In practice, analysis of economy is not done in
two watertight compartments.
Contd…………………

An Introduction to Economic Analysis 13
Interdependence of Macroeconomics and
Microeconomics
• When macroeconomic variables are analyzed,
one must allow for changes in microeconomic
variables that influence the macroeconomic
variables and vice versa

The scope of macroeconomics
includes the following parts:

Importance
• It helps to understand the functioning of a complicated modern economic system. It
describes how the economy as a whole functions and how the level of national income and
employment is determined on the basis of aggregate demand and aggregate supply.
• It helps to achieve the goal of economic growth, higher level of GDP and higher level of
employment. It analyses the forces which determine economic growth of a country and
explains how to reach the highest state of economic growth and sustain it.
• It helps to bring stability in price level and analyses fluctuations in business activities. It
suggests policy measures to control Inflation and deflation.
• It explains factors which determine balance of payment. At the same time, it identifies
causes of deficit in balance of payment and suggests remedial measures.
• It helps to solve economic problems like poverty, unemployment, business cycles, etc.,
whose solution is possible at macro level only, i.e., at the level of whole economy.
• With detailed knowledge of functioning of an economy at macro level, it has been possible to
formulate correct economic policies and also coordinate international economic policies.
• Last but not the least, is that macroeconomic theory has saved us from the dangers of
application of microeconomic theory to the problems of the economy as a whole.

The Goals of Macroeconomic Policy
• Economics analysis attempts to explain why problems arise in
the economy and how these problems can be dealt with.
• The most important goals of economic policy are:
– Full employment
– High standard of living
– Price stability
– Reduction of economic inequality and removal of poverty
– Rapid economic growth
– External balance vs overall balance of economic relations with
the rest of the world

The Circular Flow of Income
• The circular flow of income in a simple
economy where all income is consumed.
• The circular flow of income in a closed
economy.
• The circular flow of income in open economy.

The Circular Flow of Income in a Simple
Economy Where all Income is Consumed
• In this simple economy
we assume that the
household spends all
income. This spending
on consumer goods (C) is
the only component of
aggregate demand (AD)
in this simple economy
Wages and Profits (i.e. income
Rs. 2000 (y)
Household sectorProductive Sector
Private Consumption (C) Rs.
2000

The circular flow of income in a
closed economy
• A closed economy
exists when there is
no international
trade.
• It is assumed that in
closed economy
there is no
government
spending or
taxation.
Wages and Profits (i.e. income)
Rs. 2000
Household sectorProductive Sector
Private Consumption (C) Rs.
1600 Savings (S) Rs.
400
Investment
Rs. 400

The circular flow of income in an
open economy
• An open economy is
one which
international trade
exists.
• Assume also that
there is government
spending and
taxation.
Wages and Profits (i.e.
income) Rs. 2000
Household
sector
Productive Sector
Private Consumption
(C) Rs. 1600 Savings (S) Rs.
200
Imports (M)
Rs. 100
Taxes Rs. 100
Investment
Rs. 180
Exports (E) Rs.
110
Govt.
Expenditure
Rs. 110
Withdrawals (W)
Rs. 400Injections (J) Rs.
400

Measurement of
Macroeconomic Aggregates

Measurement of Macroeconomic
Aggregates
22
The Concept of The National Product
• The GNP growth rate, the most important indicator of the
nation’s economy.
• GNP and national income provide the policy makers and
business community with the most useful tool for
analyzing an economy’s performance.
• In general, GNP is the sum of all final goods and services
produced during a specific time period.
• When measuring GNP, or any other aggregate of national
product, we are interested in the final value of goods and
services.

Aggregates
23
Relationship among Eight Variants of
National Product Aggregates
- net income from abroad
-depreciation
=NDPMP
=NNPFC
GDPMP
GNPMP
=NNPMP
=NDPFC
=GDPFC
=GNPFC
-net indirect taxes
-depreciation
-depreciation
-net indirect taxes
-net indirect taxes
-depreciation
-net indirect taxes

Aggregates
24
Real vs. Nominal GNP
• Real GNP is the GNP in current rupees deflated for
changes in the prices of the items included in GNP.
• Nominal GNP are expressed in current rupees. It
measures the value of output in a given period in
the prices of that period, or as it is sometimes put ,
in current rupees.

Aggregates
25
The Measurement of National
Income
• The Output Method
• The Expenditure Method
• The Income Method

Aggregates
26
The Product Method
• It is followed either by valuing all the final goods and
services produced during a year or by aggregating the
values imparted to the intermediate products at each
stage of production by the industries and productive
enterprises in the economy.
• The sum of these values added gives the gross domestic
product at factor cost.
GDP= Total product of (industry + service + agriculture) sector

Aggregates
27
The Expenditure Method
• It aggregates all money spent by private citizens, firms
and the government within the year, to obtain total
domestic expenditure at market prices.
• This includes consumer spending and investment i.e.
total domestic spending.
• It aggregates only the value of final purchases and
excludes all expenditures on intermediate goods.
GDP = C + I + G

Aggregates
28
The Income Method
• It aggregates income of only residents of the
nation, corporate and individual, that obtain
income directly from the current production of
goods and services.
• It aggregates the money payments made to
different factors of production.
• The total of all factor of income gives total
domestic income.

GDP= Rent (Rental incomes on agricultural and non-
agricultural properties)
+ Wages/Salaries (Wages and salaries earned by
employees including supplements)
+ Interest (Net interest earned by individuals other than
governmental bodies)
+ Undistributed Profit (Profits earned by businesses
before payment of corporate taxes and liabilities)
+ Dividends
+ Direct taxes

Aggregates
30
Other Measures of National Output
• Gross national product
• Net national product
• National income
• Personal income
• Disposable income

Aggregates
31
Five Alternative Measures of Income
Depreciation
Net Indirect
Taxes
Personal
Taxes
Personal
Savings
Net Export
(E-M)
Consumer
Expenditure
(C)
Gross Private
Domestic
Investment (I)
Government
Purchases (G)
Wages
Proprietors
Income
Interest
Rents
Corporate
Profit
Minus
Corporate profits
and security
insurance taxes
Plus
Transfer
Payments, net
Interest and
Dividends
Gross National
Product
GNPMP
Net National
Product
NNPMP
National
Income
NNPFC
Personal
Income
Disposable
Personal
Income
Personal
Consumption

Aggregates
32
Difficulties in Measuring National
Income
• Non-market Production
• Imputed Values
• The Underground Economy
• “Side Effects” and Economic “Bads”
• Leisure and Human Costs
• Double Counting

Aggregates
33
The Uses of National Statistics
• As an instrument of economic planning and
review
• As a means of indicating changes in a country’s
standard of living
• To indicate changes in economic growth of a
country
• As a means of comparing the economic
performance of different countries

• Say’s Law of Markets:
• Say’s law of markets is the core of the classical theory of
employment. An early 19th century French Economist, J.B.
Say, enunciated the proposition that “supply creates its
own demand.” Therefore, there cannot be general
overproduction and the problem of unemployment in the
economy.
• When a producer produces goods and pays wages to
workers, the workers, in turn, buy those goods in the
market. Thus the very act of supplying (producing) goods
implies a demand for them. It is in this way that supply
creates its own demand.

• Classical economists such as Adam Smith and Ricardo
maintained that the growth of income and employment
depends on the growth of the stock of fixed capital and
inventories of wage goods. But, in the short run, the stock
of fixed capital and wage goods inventories are given and
constant. According to them, even in the short run full-
employment of labour force would tend to prevail as the
economy would not experience any problem of deficiency
of demand.
• On the basis of their theory they denied the possibility of
the existence of involuntary unemployment in the
economy.

The Classical Theory of Employment:
• The classical economists believed in the existence of full
employment in the economy. To them, full employment was a
normal situation and any deviation from this regarded as
something abnormal.
• The basis of the classical theory is Say’s Law of Markets which
was carried forward by classical economists like Marshall and
Pigou. They explained the determination of output and
employment divided into individual markets for labour, goods
and money. Each market involves a built-in equilibrium
mechanism to ensure full employment in the economy.

Determination of Output and
Employment:
• In the classical theory, output and employment are determined
by the production function and the demand for labour and the
supply of labour in the economy. Given the capital stock,
technical knowledge and other factors, a precise relation exists
between total output and amount of employment, i.e., number
of workers. This is shown in the form of the following production
function: Q=f (K, T, N)
• where total output (Q) is a function (f) of capital stock (K),
technical knowledge (T), and the number of workers (N)

This is shown in Fig. 1 where the curve Q = f (N) is the
production function and the total output OQ1
corresponds to the full employment level NF. But when
more workers NfN2 are employed beyond the full
employment level of output OQ1, the increase in
output Q1Q2 is less than the increase in employment
N1N2.

Labour Market Equilibrium:
• In the labour market, the demand for labour and the supply of labour
determine the level of output and employment. The classical economists
regard the demand for labour as the function of the real wage rate: DN =f
(W/P)
• Where DN = demand for labour, W = wage rate and P = price level. Dividing
wage rate (W) by price level (P), we get the real wage rate (W/P).

Wage Price Flexibility:
• The classical economists believed that there was always full
employment in the economy. In case of unemployment, a general
cut in money wages would take the economy to the full
employment level. This argument is based on the assumption that
there is a direct and proportional relation between money wages
and real wages.
• When money wages are reduced, they lead to reduction in cost of
production and consequently to the lower prices of products. When
prices fall, demand for products will increase and sales will be
pushed up. Increased sales will necessitate the employment of
more labour and ultimately full employment will be attained.

Goods Market Equilibrium:
• The goods market is in equilibrium when saving equals investment.
At that point of time, total demand equals total supply and the
economy is in a state of full employment. According to the
classicists, what is not spent is automatically invested.
• Thus saving must equal investment. If there is any divergence
between the two, the equality is maintained through the
mechanism of the rate of interest. To them, both saving and
investment are the functions of the interest rate.

• To the classicists, interest is a reward for saving. The higher the rate of interest,
the higher the saving, and lower the investment. On the contrary, the lower
the rate of interest, the higher the demand for investment funds, and lowers
the saving. If at any given period, investment exceeds saving, (I > S) the rate of
interest will rise.

Money Market Equilibrium:
• The money market equilibrium in the classical theory is based on
the Quantity Theory of Money which states that the general
price level (P) in the economy depends on the supply of money
(M). The equation is MV= PT, where M = supply of money, V=
velocity of circulation of M, P = Price level, and T = volume of
transaction or total output.
• The equation tells that the total money supply MV equals the
total value of output PT in the economy. Assuming V and T to be
constant, a change in the supply of money (M) causes a
proportional change in the price level (P). Thus the price level is
a function of the money supply: P = f (M).

In this approach, the concept of income velocity of money has been
used instead of transactions velocity of circulation. By income velocity
we mean the average number of times per period a unit of money is
used in making payments involving final goods and services, that is,
national product or national income. In fact, income velocity of money
is measured by Y/M where Y stands for real national income and M for
the quantity of money.
MV = PY
P = MV/PY
Where
M = Quantity of money
V = Income velocity of money
P = Average price level of final goods and services
Y = Real national income (or aggregate output)
Quantity Theory of Money: Income Version:

• More specifically, they do not vary in response to the
changes in M. In fact, real income or output (Y) is
assumed to be determined by the real sector forces such
as capital stock, the amount and skills of labour, tech-
nology etc. But as these factors are taken to be given and
constant in the short run, and further full employment of
the given resources is assumed to be prevailing due to
the operation of Say’s law and wage-price flexibility
supply of output is taken to be inelastic and constant for
purposes of determination of price level.

Quantity Theory of Money: The
Cambridge Cash Balance Approach:
• The equation of exchange has been stated by Cambridge economists,
Marshall and Pigou, in a form different from Irving Fisher. Cambridge
economists explained the determination of value of money in line with
the determination of value in general.
• Value of a commodity is determined by demand for and supply of it
and likewise, according to them, the value of money (i.e., its
purchasing power) is determined by the demand for and supply of
money. As studied in cash-balance approach to demand for money
Cambridge economists laid stress on the store of value function of
money in sharp contrast to the medium of exchange function of money
emphasised by in Fisher’s transactions approach to demand for money.

According to cash balance approach, the public likes to hold a proportion of nominal
income in the form of money (i.e., cash balances). Let us call this proportion of
nominal income that people want to hold in money as k.
Then cash balance approach can be written as:
Md =kPY ….(1)
Y = real national income (i.e., aggregate output)
P = the price level PY = nominal national income
k = the proportion of nominal income that people want to hold in money
Md = the amount of money which public want to hold

• Now, if supply of money fixed by the Government (or the Central Bank) is
equal to M0, the demand for money equals the supply of money, M0 at price
level P0. Thus, with supply of money equal to M0 equilibrium price level P0 is
determined. If money supply is increased, how the monetary equilibrium will
change? Suppose money supply is increased to M1 at the initial price level P0
the people will be holding more money than they demand at it.
• Therefore, they would want to reduce their money holding. In order to reduce
their money holding they would increase their spending on goods and
services. In response to the increase in money spending by the households the
firms will increase prices of their goods and services.
• As prices rise, the households will need and demand more money to hold for
transaction purposes (i.e., for buying goods and services). It will be seen from
that with the increase in money supply to M1 new equilibrium between
demand for money and supply of money is attained at point E1 on the demand
for money curve kPY and price level has risen to P1.

Macro unit 1

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Macro unit 1