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Synopsis of Macroeconomics
Introduction to Macroeconomics
Economics can best be defined as the science of scarcity and choice. The basic economic problem is the
existence of limited resources and unlimited wants. An economy or an individual has to choose among the
competing wants. A rational decision of choice will be based on the opportunity cost involved in making a
decision. Any decision to purchase or produce a good, will involve forgoing the chance to purchase or produce
some other thing. This opportunity forgone while obtaining a thing is known as the opportunity cost.
Positive economics mainly deals with objective statement of facts, free of any value judgments, whereas
normative economics deals with subjective statements in the form of what should be which contains value
judgments.
Microeconomics studies single economic units like individual households and firms while macroeconomics
studies the economy as an aggregate. But the conclusions drawn from a microeconomic situation cannot be
extended to a macroeconomic situation because what is true in a particular instance may not be true in an
aggregate. The path from micro to macro is laid with difficulties. One such difficulty is macroeconomic paradox.
Again the variables will affect each other so that its interdependence cannot be denied.
In a classical setting when full employment (aggregate demand always equals aggregate supply) was assumed
to be the normal state of affairs microeconomics reigns supreme. As resources are fully employed the main
task was assumed to be allocation of resources like deciding what is the output level of a firm, what is the price
determined by it, consumption decision by an individual and so on. After the Great Depression, it is realized
that all the resources are not fully utilized (aggregate demand can fall short of aggregate supply) the shift of
emphasis turned from microeconomics to macroeconomics.
Production Possibility Curve shows all possible combinations of two outputs that can be produced given the
fully employed resources and existing technology. The production of more of one good implies the less of
some other good and all the resources are not equally efficient in producing a particular good. The PPC slopes
downward and is convex to the origin.
Knowledge of economics helps decision makers like managers and economists a lot. Economics provides all
the adequate tools of analysis to make rational decisions, which are in the interest of the firm or economy.

National Income
Economic performance of a country can be evaluated from the GNP/or GDP of a country. GNP is the sum of
the market value of all final goods and services produced during a specified period of time. If the same is
estimated in terms of the income earned by the factors of production we will get GNP at factor cost. Value of
the intermediate goods will be excluded in order to avoid the problem of double counting.
In order to account for the price changes real GDP is calculated instead of nominal GDP. The real GDP/GNP is
the GNP/GDP in current prices deflated for changes in the prices. A price Index called GNP deflator is
constructed to reveal the changes in the purchasing power. Price Indices like CPI and WPI are also constructed
to capture the changes in the overall price level.
Output, expenditure and Income methods are used to measure the National Income of a country. Output
Method aggregates the value of all goods and services produced in a given year excluding the intermediate
goods. Expenditure method aggregates all the expenditures on final goods and services. Income method
aggregates all the factor incomes earned. The chapter also presents a National Income Accounting System
through an example of a hypothetical economy.
Classical theory
Aggregate supply in the classical model is vertical in shape due to the flexible wage and price level. The AS
curve is derived from the production function and the demand and supply of labor function. Production is a
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function of capital and labor and capital is assumed to remain constant. Labor will be employed up to the point
where the real wage and the marginal productivity of labor are equal.
Supply of labor and the real wage are positively related. Full employment equilibrium output is always
maintained by the adjustment of the wage and price level. In the classical model interest rate is flexible and the
adjustment in the in interest rate always maintains the saving-investment equality. Classicists believe in the
difference between the real and monetary variables.
A change in money supply will not bring about any change in the real variables like output and the real wage
rate. It will affect only the real variable like the price level.

Keynesian theory
At equilibrium output level, AD will be equal to the total income, AD = Y. AD is a sum total of consumption,
investment, government functions and the Net Exports. AD = C + I + G + NX. Therefore equilibrium level of
output is that level of output at which the quantity of output produced is equal to the quantity demanded, Y = C
+ I + G + NX.
Multiplier ( ) explains the level of increase (decrease) in the equilibrium output as a result of a unit increase
(decrease) in the autonomous spending. The value of multiplier is the reciprocal of the value of the Marginal
Propensity to Save (MPS),
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MPS
. The MPC and the value of the multiplier are directly related to each other.
When we introduce the government sector into our model (three sectors) the increase in equilibrium income
will be equal to the change in government expenditure times the multiplier, G . . If the budget of a
government is balanced (tax revenue = government expenditure) the value of the multiplier will be one. In an
open economy where foreign trade is allowed, the AD schedule will be equal to
C + I + G + X M.
The consumption function is determined by the price expectations, stock of wealth, taxes, distribution of
income etc. Investment function is primarily determined by the income and rate of interest. Investment and
income are directly related and investment and interest rate are inversely related. Another important factor
influencing investment is the Marginal Efficiency of Investment Spending. Investors will undertake new
investment on the basis of comparing the interest costs and the expected annual rate of return.
Acceleration Principle explains the change in the level of output and the volume of investment expenditure. It
explains by how much an investment outlay should change as a result of change in the demand for final output.
The technical relationship between the quantity of output and the quantity of capital necessary to produce a
given level of output is given by this theory. V =
K
Y
signifies the accelerator. If there is no excess capacity or
if the capital is fully utilized an increased demand for output will require an increase in investment outlay to
meet the increased demand.
Supply creates its own demand was the fulcrum of classical analysis. Keynesians believed in demand-
determined production. As the production is demand-determined if some unexpected changes occur in
expenditure and if it falls short of the supply, unemployment will prevail and it cannot be corrected by any
automatic mechanism. However, whereas, in the classical model, flexible wage and price mechanism will bring
the economy back to the full employment level. In the Keynesian model, wages are rigid downwards due to
the trade unions. Keynesian AS curve has three portions one horizontal part where the price level does not
change, upward sloping part due to the rigidity of wage downwards, and a vertical part after attaining full
employment.
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Keynes added one more important dimension of the demand for money, i.e., speculative demand for money.
Speculative demand for money is inversely related to the interest rate. Keynes rejected the classical dichotomy
and the neutrality of money.

Aggregate Demand and Aggregate Supply
Aggregate Demand curve shows the combinations of price level and the income/output level at which goods
and money markets are simultaneously in equilibrium. AD is a downward sloping curve indicating the negative
relationship between the price level and the quantity of total goods and services demanded in an economy. The
AD curve is derived from the
IS-LM diagram where the price level is allowed to vary.
Fiscal and monetary policy causes shifts in the AD curve. If an expansionary fiscal policy is implemented, the
IS curve shifts outward to the right causing an increase in the interest rate and the income level. The quantity
demanded will increase at the increased income level and the given price level. Therefore the AD curve will
shift outward. A contractionary fiscal policy will bring in the opposite result. AS a result of expansionary
monetary policy the LM curve will shift outward and consequently the AD curve will do so too.
In the short run the aggregate supply will be influenced by the changes in the price level, because the firms will
not be able to predict the exact price level. This causes disparity between the expected and the actual price
level. The AS curve is upward sloping from left to right, because the supply will increase with an increase in
price level until full employment is reached. After this limit is reached the AS curve will become vertical. In
the long run the expected and the actual price level will be the same. If the price is increased the cost of the
firm will also increase and therefore there is no incentive for the producers to produce more. Therefore, the AS
curve is vertical in the long run. Equilibrium is reached by the intersection of the short run and long run AS
curve with the AD curve determining the natural rate of output and the price level where the quantity
demanded and supplied are equal.
Besides changes in the price level, there are lot of other factors which cause shifts in the AS and AD curve. AD
curve is influenced by the change in income and wealth, interest rate, government policy, exchange rate etc.
AS is influenced by changes in the cost of production, supply shocks, technological changes, human capital
etc.
Inflation
Inflation refers to the general increase in the prices of a basket of goods and services over a period of time.
On the basis of the speed at which the prices increase inflation can be classified as: creeping inflation,
galloping inflation and hyperinflation.
Inflation has its impact on distribution of income, wealth, output and economic growth. As prices increase the
wage earners income will not increase as fast as the increase in prices, hence the income gets transferred from
wage earners to the producers. Similarly, the debtors are the gainers and the creditors are the losers during
inflation.
In the short run inflation has an impact on the output and in the long the impact will depend on the speed with
which wages adjust to the changes in prices.
In the AD-AS framework inflation can occur as a result of demand side factors or supply side factors or both.
Demand-pull inflation occurs as a result of changes in factors affecting demand. Cost-push inflation occurs as a
result of decrease in aggregate supply.
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The Philips Curve gives the inverse relationship between rate of change in wages and the level of
unemployment. As the wages increase at a faster rate the unemployment rates are low and wages increase at a
slower rate. Hence, the unemployment levels are high.
Stagflation refers to the coexistence of stagnation and inflation. This was experienced in 1970s, which meant
that the Phillips Curve is valid in the short run and in long run there is no trade-off between inflation and level
of unemployment.
In case of India both demand-pull and cost-push factors have an impact on the rate of inflation. Some of the
demand-pull factors are, hoarding of essential commodities, speculation about increase in prices, black money
and rapid increase in population. Some of the supply side factors are, imperfect markets, wide fluctuations in
output, upward revision of administered prices, oil shocks, global inflation and increase in indirect taxes and
supply shocks.


Money supply and Banking

Four concepts of money supply compiled by the RBI are: M
1
, M
2
, M
3
and M
4
. The RBI emphasizes the narrow
money M
1
and the broad money M
3
. In the Money Multiplier Approach, money stock is determined by the
money multiplier and the monetary base, i.e., M
S
= mH. H is high-powered money, which constitutes currency
with the public and reserves. An increase in the high-powered money will change the total money supply by a
multiple of that increase.
The actual process of money creation happens with the commercial bank. When customers open an account by
depositing money, it becomes a liability to the bank. When banks give loans to the borrowers they are credited
to borrowers account. Loans are the children of deposits and deposits are the children of loans. Loans are
assets to the banks. Credit creation may be initiated by the Central Bank and will result in a multiple expansion
of credit/money through the commercial banks.
The supply of and demand for money determines the money market equilibrium. The intersection point of the
demand for real balances and the supply of money determine the equilibrium rate of interest at which the
money market will be in equilibrium. Changes in the equilibrium happen due to the changes in the money
supply and the real income of the individuals. Equilibrium will be established by interest rate adjustments.
IS-LM Framework
IS curve derives equilibrium in the goods market. IS curve is a locus of the combinations of interest rate and
income where investment equals savings and aggregate demand equals aggregate output. The value of the
multiplier and the steepness of the IS curve are inversely related. Any increase in autonomous expenditure will
shift IS curve rightward and vice versa. Points, off the IS curve indicate disequilibrium.
LM curve represents equilibrium in the money market. LM curve traces the interest rate and income level
where the supply and demand for money will be equal. The liquidity preference increases if the interest rate
declines and vice versa. LM curve will be steeper if lesser the responsiveness of demand for money to the
interest rate and more to income. An increase in the money supply will cause shifts in the LM curve.
An intersection of IS and LM curve brings in simultaneous equilibrium in the goods and money market.
In order to achieve the objectives of economic policies. Monetary and Fiscal policies have been complemented.
Monetary policy is an important instrument through which the Central Bank controls the supply and cost of
credit in an economy. Though monetary policy has its primary impact on the money market, it affects the
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goods market also, as the two markets are interconnected. Monetary mechanism represents different routes
through which monetary policy affects the goods market.
Fiscal policy is defined as an instrument through which government changes its taxation and expenditure
pattern in order to achieve economic goals of the economy. An expansionary fiscal policy may cause crowding
out of private investment expenditure by increasing the interest rate. This can be prevented by a wise mixture
of expansionary monetary policy.

Business Cycles
Fluctuations in economic activity affect the level of output, level of employment and hence the standard of
living of the people. Until the 1970s, economic growth in India was very low but since mid 1980s it picked up
momentum.
Business cycles refer to fluctuations in economic activities. Economic activities refer to consumption,
production, exchange and distribution. The fluctuations are regular in nature and occur at regular intervals.
The various phases of business cycle are: recovery, prosperity, boom, recession and depression. Each of these
occurs in a sequential manner and one phase leads to the other. The various theories of business cycle are
essentially based on finding the factors affecting the various phases of the business cycle.
Stabilization policies are aimed at reducing fluctuations in economic activity. Government uses various
policies by studying various indicators of business cycles. The indicators of various phases of business cycle
can be classified into lead and lag indicators.
Some of the important causes for fluctuations of output in India are: erratic agricultural production, changes in
public expenditure and changes in the policies of the government.
The different types of unemployment are: frictional unemployment, structural unemployment, cyclical
unemployment and technological unemployment. Full employment and natural rate of unemployment are the
two important concepts that are used to explain the level of unemployment in a country.
In India, the problem of unemployment is both structural and disguised in nature. Officially, unemployment in
broadly classified into urban and rural unemployment. These are further classified into industrial, educated,
open and disguised unemployment.
The National Sample Survey Organization (NSSO) uses various concepts to measure unemployment in India:
Usual status, weekly status and daily status. The Government of India has taken up many employment
generation programs in both urban and rural areas.
Disguised unemployment results in increase in burden on the productive consumer and conceals the savings
potential. Nurkse has suggested that the excess labor should be withdrawn from agricultural sector and should
be gainfully employed in the other sectors. This will help in increasing both the savings and the consumption.
Monetary Policy
The main functions of the central bank are: (a) central bank as a bank of issue or monopoly of note-
issue, (b) the central bank as the governments banker, agent and advisor or governments bank, (c)
the central bank as the custodian of the cash reserves of commercial banks or bankers bank, (d)
central bank as the custodian of the nations reserves of international currency, (e) controller of
credit.

The central bank in India is known as the Reserve Bank of India. The main objectives of the Reserve
Bank of India are regulation and control of the volume of money supply (currency and bank
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money), issue of currency notes and maintenance of foreign exchange reserves and provision of
advice to the government on economic issues.
The monetary policy regulates the supply of money and the cost and availability of credit in the
economy. Regulation of money supply has its effect on interest structure, credit structure,
investment structure, prices and flow of foreign exchange, etc. The monetary policy aims at
maintaining price stability, full employment and economic growth.
The important objectives of monetary policy are: high rate of growth, price stability, exchange
stability, productive and speculative uses of money etc.

Fiscal Policy
Tax and expenditure policies constitute fiscal policy of a government. Taxes are generally constructed
following the equity policy. Two basic strands of this are Benefit principle and Ability to Pay principle. Tax
base shows where the money comes from. Tax rate is the percentage of income taxed. Tax rate structure can be
divided into Progressive, Regressive and proportional taxation. Tax incidence looks into the aspect of who
bears the ultimate burden of tax. In its stabilizing role the government can influence the macroeconomic
equilibrium of an economy by using its expenditure and taxing powers
Open economy
As all the countries in the world cannot produce what all they want they engage in international transactions or
trade. An economy, which is open to international trade, is an open economy. As economies are differently
endowed with natural resources, technology etc., nations participate in international trade. An important reason
for international trade is differences in costs. In order to take advantage of the differences in costs and cost
ratios nations engage in trade. According to the theory of absolute advantage, countries should specialize in
and trade those goods in which they have an absolute advantage over the other country. If a country does not
have absolute advantage in any of the goods, it should specialize in the production of those goods in which it
have a comparative advantage.
Protectionist policies help some of the countries to be protected from aggressive international trade. It will help
the domestic economies to protect some of their infant industries from severe competition from foreign
exports. Exchange rate is the number of units of one currency needed to purchase one unit of another currency.
Balance of Payments is the systematic record of a countrys economic transitions with the rest of the world. All
items are entered as either credits or debits. Balance of Payments is constituted of current account and capital
account. Current account records all transactions in merchandize and invisible items. All transactions of
financial nature are included in the capital account.
Internal and external balances can be attained through fiscal and monetary policies. Some conflicts can be
solved by assigning external balance to monetary policy and internal balance to fiscal policy.







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