Macroeconomics EPBM 16

Sudip Chaudhuri 1st Part (Topics 1 to 3)

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Topics
1.Overview of Macroeconomics 2.National Income Accounting 3.Business Cycles and Multiplier 4.Money and Monetary Policy 5.Balance of Payments and Foreign Exchange Rates 6.Open Economy Macroeconomics 7.Strategy of Economic Development

Topic 1
Overview of Macroeconomics

What is Macroeconomics?
Microeconomics focuses on how decisions are
made by individuals and firms and the consequences of those decisions

Macroeconomics examines the

aggregate behavior of the economy how the actions of all individuals and firms in the economy interact to produce a particular level of economic performance as a whole.
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Great Depression
The sharp fall in aggregate output and employment levels which started in 1929 and lasted through the 1930s

This gave rise to modern macroeconomics

Macroeconomic theory changed dramatically with the 1936 publication of the book, The General Theory of Employment, Interest and Money by John Maynard Keynes Important mission of modern macroeconomics: to prevent anything like the Great Depression from happening again
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The Great Depression

Potential Output

Potential output

K : Total physical capital stock, i.e., total final investment goods installed in the economy at a point of time Potential output: Maximum possible production level (at constant prices) during the period (year), given K, supply of labour, human capital, technology etc
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Goods and services produced

Intermediate goods and services, i.e, those which are used up in the process of production, e.g., yarn for weaving cloth, ironore for producing steel, fertilizers for producing wheat Final consumption goods and services, i.e., those which are purchased by the household sector. Examples are: rice, garments, fees paid to doctors, bus fare refrigerator, TV Final investment goods, i.e., durable goods like plant and machinery, buildings, roads, bridge
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Demand-constrained economy
(aggregate demand < potential output)

(Recession/depression)
Aggregate demand Potential amount not produced

Potential output

Recession/depression
Recession:

Decline in output, income and employment lasting more than few months a recession that is large in both scale and duration

Depression:

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Supply-constrained economy
(aggregate demand > potential output)

(Demand-pull inflation)
Aggregate demand

Potential output

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Inflation
Demand-pull inflation Cost-push inflation Stagflation

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Market
Is a mechanism through which buyers and sellers interact to determine prices and exchange goods and services Different types of market:
Details in the next Economics course

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Competitive Market
Is a market in which there are many buyers and sellers of the same good or service Three elements:
Demand curve Supply curve Equilibrium price

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Market Equilibrium

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Shifts in Supply or Demand Change Equilibrium Price and Quantity

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Macroeconomics
Three central questions Why do output and employment sometimes fall and what can be done about it What are the sources of inflation and how can it be controlled How can a nation increase its rate of economic growth

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Why demand is deficient and how it can be increased

Aggregate demand

Potential output

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How demand can be managed to tackle demand-pull inflation

Aggregate demand

Potential output

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How K (and productivity etc) can be increased to accelerate growth

Potential output

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Measuring economic success

Growth of output - GDP and per capita GDP/GNI Price stability - Inflation rate Low unemployment (and poverty) rates External balance:
Trade deficit Current account deficit (CAD) BOP deficit

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Growth rate
Growth rate of GDP (percent) ((GDPt GDPt-1 )/GDPt-1 ) x 100 Inflation rate ((Pt Pt-1 )/Pt-1 ) x 100, where P: Annual averages of price indexes Or Year-on-year
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Purchasing Power parity

The PPP between two countries currencies is the exchange rate at which a given basket of goods and services would cost the same amount in each country Suppose a basket of goods and services that costs $ 100 in USA, costs Rs 900 in India. Then the PPP is Rs 9 per US $ Re-$ PPP is approx 20% of the market exchange rate 27

Real GDP per capita

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InIndia, W holesaleP Index m com on thanC rice ore m onsum P er rice

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P ersons belowPoverty lineinIndia

Rural Percentage 1973 1983 1993 2004 Number (Lakhs) 1973 1983 1993 2004 56.4 45.7 37.3 28.3 Urban 49.0 40.8 32.3 25.7 Combined 54.9 44.5 36.0 27.5

2612.9 2519.57 2440.31 2209.24

600.46 709.4 763.37 807.96

3213.36 3228.97 3203.68 3017.20

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Tools of Economic Policy

Fiscal Policy:
Government expenditure and taxes

Monetary Policy:
Money supply, credit, interest rates

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Recommended text
Paul Samuelson and William Nordhaus Economics, 19th edition Tata McGraw Hill Indian Adaptation by Sudip Chaudhuri and Anindya Sen, Chapters 19 to 31

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For Examination
PPTs uploaded Class discussions Economics, 19th edition:
Chapter 19 (except pages 476 to 481) Chapter 20 Chapter 21 Chapter 22 (except pages 557 to 559) Chapter 23 (except pages 593 to 595; 602 to 605) Chapter 24 (except pages 625 to 638) Chapter 27 (except pages 720 to 724) Chapter 28 (except pages 745 to 757)

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Some useful sources of data

UNDP: http://hdr.undp.org/en/statistics/data/ IMF: http:// www.imf.org/external/pubs/ft/weo/2008/01/weodata/index.a World Bank: http://worldbank.org RBI: http:// www.rbi.org.in/scripts/AnnualPublications.aspx?head=Han Min of Finance: http://indiabudget.nic.in/ CSO: http://mospi.gov.in/mospi_cso_rept_pubn.htm

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Topic 2
National Income Accounting

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The National Accounts

Almost all countries calculate a set of numbers known as the national income and product accounts. The national income and product accounts, or national accounts, keep track of the flows of money between different parts of the economy.

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In India
Central Statistical Organization, New Delhi publishes every year the National Accounts Statistics (http://mospi.gov.in/mospi_cso_rept_pubn.htm) (New users can register free)

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Gross Domestic Product

Market value of all FINAL goods and services produced within a country in a given period of time Note:
Included in GDP:
Not only goods but also services Only those with market value Even if not sold

Excluded in GDP:
Financial assets like stocks Foreign produced goods & services Used goods

FINAL: does not mean intermediate goods & services are ignored

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Two ways of calculating GDP

Final use (or Flow of product) method
Here we ignore the intermediate goods and services and concentrate only on the Final goods and services which have not been used up in the process of production GDP is calculated by adding the value of production of all the final goods and services produced, i.e., the value of production of all the final consumption and investment goods and services.

Income (or earnings) method

GDP is calculated by adding all the factor incomes accruing to the household sector.
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Some definitions
Value of production is defined as (quantity of production) x (price of the product). Thus the value of cloth produced = (quantity of cloth produced in meters) x (the price per meter) Profits = Sales wages raw materials/services costs Thus Sales = profits + wages + raw materials/services costs Value added is defined as Value of production cost of raw materials purchased = Profits + wages (Note: other incomes are interest and rent)
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Cloth

R: profits W: wages

R1 Yarn W1 R2 W2 Yarn cost Cotton cost R3 W3

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C otton

Problem of double counting

Problem arises if we take value of production of all goods and services, i.e., both intermediate and final Problem tackled by taking:
VALUE OF PRODUCTIONof ONLY FINAL goods and services or VALUE ADDED of ALL goods and services

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Thus
GDP = C + I + G + X (Product approach) = Profits + wages + other incomes + depreciation + net production taxes (Earnings approach) Aggregate production generates equivalent incomes
Note: GDP at market price = GDP at factor cost + indirect taxes subsidies.

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Where
C: Consumption = aggregate consumption expenditure by households on goods and services I: Private Investment = aggregate investment expenditure by private sector = Fixed investment = expenditure on final investment goods (durable goods like plant, machinery, buildings) + Net change in inventories G: Aggregate government expenditure on goods and services including on investment goods X: Net exports = Aggregate exports of goods and services minus Aggregate imports of goods and services NOTE: If I = total I, then G = consumption expenditure 45

Why Imports are deducted

GDP =

(C Cm) + (I Im) + (G Gm) + (Ex Exm), where Ex: exports Or, GDP = C + I + G + Ex (Cm + Im + Gm + Exm) Or, GDP = C + I + G + Ex M, where M = Cm + Im + Gm + Exm Or, GDP = C + I + G + X

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Circular Flow Diagram

The Flows of money, goods and services and factors of production

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Circular Flow Diagram

Connects the four sectors of the economy
Households Firms Government and the Rest of the world

Via three types of markets

the factor markets the markets for goods and services and the financial markets

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Two-Sector Circular Flow Diagram

Consumer spending HOUSEHOLDS Goods & services bought Market for goods & services Goods & Services sold FIRMS Revenue Wages, rent, interest, dividends
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Income

Land, Labour, capital Factor markets Factors of production

Govt exp on goods & services Taxes Consumer spending Market for goods & services GDP I spending Exports Imports

Government Salaries Households

Government borrowing Transfers Household savings

Wages etc Factor markets Wages etc Firms Barrowing & stocks issued Rest of World Foreign borrowing etc Foreign lending etc
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Financial markets

Demand-constrained economy

Aggregate demand = C+I+G+X

Potential output

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GNP (or GNI)

Gross national product or Gross national income is defined as the sum total of the incomes which accrue to the residents of the country Residents individuals and enterprises:
Not based on nationality or legal criteria but on Center of Interest in the economy
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GNP (or GNI)

GNP = GDP + (earnings of residents from supply of factors of production to non-residents) (payments made by residents to nonresidents for factors of production received) Or, GNP = GDP + net factor earnings of the residents from the rest of the world

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Real GDP
GDP at constant prices to find out how aggregate production has changed in real terms
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Example
Year 1 Quantity of apples Price of apple 2000 Rs 10 Year 2 2200 Rs 15 1200 Rs 7.5 Rs 42000 Rs 28000
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Quantity of oranges 1000 Price of orange Nominal GDP Real GDP Rs 5 Rs 25000 Rs 25000

Real GDP
Real GDP (GDP at constant prices)
it is the total value of final goods and services produced in the economy during a year, calculated as if prices had stayed constant at the level of some given base year (1999-2000; recently changed to 2004-05)

Nominal GDP (GDP at current prices),

GDP number that has not been adjusted for changes in prices is calculated using the prices in the year in which the output is produced

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Inflation
Process of overall price rise Calculated on the basis of price indexes:
WPI more common than CPI in India

Implicit GDP deflator (ratio of Nominal GDP/Real GDP)

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Price Indexes used in India

Wholesale Price Index (WPI)

Base yearCompiled by
1993-94 Office of the Economic (recently Adviser, Ministry of changed to Commerce and industry 2004-05) 2001 Labour Bureau, Ministry of Labour and Employment Labour Bureau, Ministry of Labour and Employment Labour Bureau, Ministry of Labour and Employment Central Statistical Organization
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Consumer Price Index for Industrial Workers (CPI-IW) Consumer Price Index for Agricultural Labour (CPI-AL Consumer Price Index for Rural Labour (CPI-RL) Consumer Price Index for Urban, Rural and Combined

1986-87

1986-87

2010

WPI
Base year 2004-05 (2004-05 = 100) 676 products (consumer, intermediate and capital) with value weights assigned:
Rice, wheat, vegetables, petrol, biscuits, textiles, medicines, cement, TV sets, motor vehicles etc

Services not included Wholesale prices (not retail prices) from selected markets Indices calculated for products/sub-groups/groups/all commodities by calculating the weighted average of price ratios between the current period and the base year Monthly/weekly data published in www.eaindustry.nic.in

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WPI
No of products All commodities Primary articles Fuel, power 676 102 19 Weights 100.00 20.12 14.91 64.97

May, 2011
151.7 192.1 160.4 137.2

Manufactured products 555

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Inflation rate
((Pt - Pt-1 )/Pt-1 )*100 Annual averages:

Pt= 52 week/12 month average of

year year.

the index in a particular the index of the previous

Pt-1 = 52 week/12 month average of

Year-on-year (point-to point) basis:

Pt= Pt-1

Index in a particular week/month = Index 52 weeks/12 months earlier

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Nominal/Real Interest rate

Real interest rate = Nominal interest rate Inflation rate

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Topic 3
Business Cycles and Multiplier

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Questions
What causes aggregate income to rise? To fall? What causes too little spending recession and depression? What causes too much spending demand pull inflation?

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Assume: Demand-constrained economy

Aggregate demand

Potential output

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In reality
Given a particular K, an economy necessarily does not produce the maximum possible output How much is produced depends on the size of the market Most of the recessions in the post World War II can in fact be explained by reductions in aggregate demand
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What are the factors which influence aggregate demand?

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Govt exp on goods & services Taxes Consumer spending Market for goods & services GDP I spending Exports Imports

Government

Households

Factor markets Wages etc Firms Rest of World

Financial markets

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Initial assumption
Closed economy No government Two sectors:
Households Firms

Hence two types of aggregate demand:

Consumption and Investment
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Households, typically
Use a part of their income for consumption And save the other part

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Firms
Investment expenditure:
Planned investment (mainly fixed investment expenditure, i.e., expenditure on final investment goods such as plant, machinery) Unplanned inventory adjustment

Use retained earnings (business savings) and loans and other sources to fund investment

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Consumption Expenditure
Depends on: Current disposable income (DI) And other factors such as:
Expected future income Wealth

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Consumption Function
Relationship between C and DI, other factors remaining constant

MPC: marginal propensity to consume = C/ DI = change in C when DI changes by a unit

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C onsum functionother factors rem ption ainingthesam e

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Planned Investment Expenditure

(= investment spending = investment demand)

Private Investment undertaken for profits Private investment demand depends on:
Revenues generated by the investment project Interest rates (and taxes) that influence the costs of investment Business expectations about the state of the economy
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Expectations
Are subjective Are often influenced by current and recent rates of return But can be highly volatile due to changes in the business climate:
Political, ideological, psychological and other influences on future expectations

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C D E F G H

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How aggregate demand determines aggregate output and income

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Aggregate Demand Curve (=Total Expenditure Curve)

TE

TE (=C+I) C

I is constant by assum ption

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Assumptions
Firms produce more (subject to capacity constraints) if market demand is greater than their current production Firms produce less if market demand is less than their current production (Prices are not changed till full capacity is reached)
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How Aggregate Demand determines Y

TE
E1 E*

0
2

TE
E2

01

Potential output 45

Y1

Y*

Y2

At Y1, Total demand (=E1Y1) Total production (=0Y1=01Y1) At Y2, Total demand (=E2Y2) Total production (=0Y2=02Y2) At Y*, Total demand = Total production Y* is the equilibrium Y
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Use of 450 line

0
E1 E*
2

TE
E2

01 Potential output
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Y1

Y*

Y2

Note: 01 and 02 are in the 450 line Thus 0Y1 = 01Y1 and 0Y2 = 02Y2. The 45 line basically helps to compare demand (measured in y-axis) and supply (measured in x-axis) 89 At Y1, E1Y1 > 0Y1 and at Y2, E2Y2 < 0Y2

Equilibrium Income level

Is the level where the system tends to stay It is not necessarily the optimal level In the previous example, the equilibrium point Y* is sub-optimal - it is less than the potential output
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Recessions/Expansions
45-degree line TE
Upward shift in demand

TE

Downward shift in demand

Potential output

Y1

Y*

Y2

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Recessions/Expansions
Exogenous vs Internal cycles Examples of crises
New economy bubble in late 1990s Housing bubble in late 2000
Crash in real estate: Investment in housing falls As business climate worsens, firms reduce I People affected reduce C

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Impact of Increase of Spending on Income: Multiplier Analysis

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Multiplier
A Change in investment spending arising from say a change in future expectations starts a chain reaction in which the initial change in aggregate production leads to changes in consumer spending leading to further changes in production levels. Thus production ultimately increases more than the initial increase in investment spending
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How multiplier works

Expenditure = I + b I + b2 I +.. (= Demand) Production (= Y ) = I + b I + b2 I + .. = I (1+ b + b2 +.) =1-b I

where b : marginal propensity to consume 0<b<1

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How multiplier works I = Rs 10

Expenditure = 10 + b10 + b2 10 +.. (= Demand) Production (= Y ) = 10 + b10 + b2 10 +.. = 10 (1+ b + b2 +.) = 10

where b : marginal propensity to consume 0<b<1 If b= , then, ultimately, Y = Rs 10(4) = Rs 40

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1-b

Multiplier
TE

45-degree line TE2 TE1

Potential output

Y*

Y2

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Fiscal Policy
Operates through changes in government expenditure and revenue Increasing government expenditure was Keynes solution to the Great Depression

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Fiscal Policy
Can play a very important role in recession/depression when investment demand is not very sensitive to changes in the interest rate and monetary policy may not be very effective Recall: Interest alone does not necessarily influence I - also important is the expected rate of return

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Expansionary Fiscal Policy

Upward shift of the aggregate demand curve through:
Larger government expenditure on goods and services (G ) - Keynes example of digging trenches and filling them up Lower taxes on households (C ) Investment tax credit; lower corporate profits taxes (I )

Output goes up not only due to the initial in expenditure but subsequent rounds of increases (recall multiplier)
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Im of governm expenditure pact ent

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Effect of Direct Taxes on Consumption Function

C
C1 (post tax C) C

As direct taxes , for same Y, Disposable Y and hence C and vice versa

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Note
If government expenditure is financed by direct taxes, net demand impact will be less During recession/depression, even if government expenditure is financed through printing of money, it may not be inflationary

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