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PRINCIPLES OF MACROECONOMICS

UNIT I: The Realm of Macroeconomics


DEFINITION OF ECONOMICS:
Economics is the social science that covers the production, distribution, and consumption of
goods and services. The word 'economics' is from the Greek for (oikos: house) and (nomos:
custom or law), hence "rules of the house (hold)."
MEANING OF THE TERM ECONOMICS:
Economics is a social science which assesses human behaviour, and in particular, the way in
which individuals and societies choose among the alternative uses of scarce resources to satisfy
wants.
DIFFERENCE BETWEEN MICRO AND MACRO ECONOMICS:
The study of economics is divided into two halves, microeconomics and macroeconomics.
i. Micro comes from the Greek word meaning small. It is the branch of economics that
studies individual units e.g., households, firms and industries. It focuses on studying
the economic behaviour of specific markets, the individual market prices, individual
firms revenues and costs of production and the employment of factors of production
at the individual market level
ii. Macro also comes from the Greek word. It is the branch of economics that studies
economic aggregates (grand totals). It is concerned with the workings of the wider
economy, including the measurement and determination of national income, output
and expenditure, and the consequences for employment and inflation. It focuses on
studying the economic behaviour of entire economies.
PRODUCTION

MICROECONOMICS

MACROECONOMIC
S

PRICES

INCOME

EMPLOYMEN
T
Production
in Individual
Wages
in Employment in
individual firms prices: Price auto industry, individual
or industries.
of gasoline, executive
business entities,
How much of apartment
salaries, etc.
number
of
steel or how many rents, milk
employees
in
cars are produced. etc.
particular
categories,
National
Consumer
National
Labour
force,
production/output price index, Income,
unemployment
, Gross Domestic inflation rate, Total
rate, Employment
Product, Growth product price corporate
in the country
in the economy, index,
profits, Total
Gross
National Aggregate
wages,
Product
price level
Minimum
wages etc.

SIMILARITIES BETWEEN MICRO AND MACRO ECONOMICS :


i. They both use some of the same tools of analysis i.e., supply and demand and
aggregation. They also rely on the same methodology of building models based on
theories and then testing their models using data.
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AGGREGATION IN MACROECONOMICS:
Aggregation means combining many individual markets into one overall market. Economic
aggregation is an abstraction that people use to describe salient features of economic life. In the
aggregate measures of macroeconomics output is output, no matter what form it takes, like
referring to soybeans or pepper or bananas or bauxite, where everything is converted into
monetary terms (value of the goods produced) instead of physical units.
FOUNDATIONS OF AGGREGATION:
The dollar is the common denominator or a measuring unit of all goods and services. Different
goods are measured in different units of measurement (pounds, yards, kilos, liters, gallons etc.)
and hence cannot be added in one measuring unit. As such the dollar becomes the common
denominator in which the value of goods is converted and it eliminates the differences in
measurement.
The aggregation in macroeconomics is based on two foundations:
The composition of demand and supply in the various markets is of little consequence for the
economy-wide issues of growth, inflation, and unemployment the issues that concern
macroeconomists.
During economic fluctuations, markets tend to move up or down together. When demand in the
economy rises, there is more demand virtually for every product or good.
Because of the above two foundations of aggregation macroeconomics and microeconomics is
divided in a different kind. In macroeconomics, we typically assume that most details of resource
allocation and income distribution are relatively unimportant to the study of the overall rates of
inflation and unemployment and in microeconomics, generally, inflation, unemployment and
growth are ignored and focus is on the distribution of resources in individual markets and
distribution of income.
GROSS DOMESTIC PRODUCT (GDP):
Outstanding economist, Simon Kuznets (1901-1985) provided the methodology for modern
National Income Accounting and developed the first reliable national income measures for the
United States. He is often referred as father of national income accounting.
Gross Domestic Product is the sum of the money values of all final goods and services
produced in the domestic economy and sold on organized markets during a specified period of
time, usually a year. It is a comprehensive measure of all the output.
Nominal GDP is GDP expressed at current prices. It is often called money GDP. Nominal GDP
is calculated by valuing all outputs at current prices.
Real GDP is GDP adjusted for changes in the price level. Real GDP is calculated by valuing
outputs of different years at common prices. Therefore, real GDP is a far better measure than
nominal GDP of changes in total production and so gives a true picture of the economy.
DISTINCTION BETWEEN GDP AND GNP:
Gross National Product equals GDP plus net property income from abroad. Net property income
from abroad represents the balance of the inflow and outflow from an economy arising from the
receipt and payment of interest, rent, dividends and profits.
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Basic Characteristics of GDP:


The GDP for a particular year includes only goods and services produced within the year. Sales
of items produced in previous years are explicitly excluded.
Only final goods and services are counted in the GDP
The adjective domestic in the definition denotes production within the geographical boundaries
of the country.
For the most part, only goods and services that pass through organized markets count for the
GDP.
Final goods and services are those that are purchased by the end user.
Intermediate good is a good purchased for resale or for use in producing another good.
Limitations of the GDP:
1. Gross Domestic Product is not a measure of the nations economic well-being.
2. International GDP comparisons are vastly misleading when two countries differ greatly in the
fraction of economic activity that each conducts in organized markets.
3. GDP places no value on leisure. The value is not included.
4. Paper transactions (transactions of shares, stocks etc.) are not counted.
5. Transactions of used goods are not included.
6. Economic bads as well as Economic goods get counted in GDP.
7. Ecological costs are not netted out of the GDP.
8. Underground activities (legal or illegal) are not counted. Only market activities are counted.
9. Household production (home cleaning, child care) are not included because they are not paid
through markets.
MACROECONOMIC CONCEPTS:
BUSINESS CYCLE:
A Typical Business Cycle Diagram

Business Cycle: The cycle of short term ups and downs in the economy.
Recession: A period during which aggregate output declines .Conventionally, a period in
which aggregate output declines for two consecutive quarters.
Depression: A prolonged and deep recession coupled with at least 10% decrease in the real GDP.
Expansion or Boom: The period in the business cycle from a Trough up to a Peak during which
output and employment grow.
Contraction , Recession or Slump : The period in the business cycle from a peak down to a
trough during which output and employment fall.
Peak : This represents a period when AD reaches a Peak and , as a result, the economy s
output is growing faster than its long term (Potential) trend and is therefore unsustainable.
Trough: The phase when the level of economic activity is at its lowest point in the Business
cycle
INFLATION refers to a sustained increase in the general price level. One of the economist
described it as too much money chasing too few goods. Inflation can be demand-pull, where
AD increases which will increase the price level or cost-push where the cost of resources forces
the suppliers to increase the price of the goods being supplied. During a period of inflation there
is an increase in the overall price level and in a diagram it will be seen as an outward shift of the
aggregate demand curve. Because of increase in demand for goods the services the price level
will increase, investments will increase and unemployment will decrease and a new equilibrium
position will be achieved.
Inflation benefits borrowers and the lenders will lose because of decrease in the money value.

P
r
i
c
e

AS

L
e
v
e
l

E2

E1
AD 2

AD 1

Output/ Real GDP

RECESSION is a period during which the total output of the economy declines for two to three
quarters of a year. During this period, the businesses close down, investments decrease, price
levels may decrease and unemployment will increase. The AD curve will shift inwards.
If recession continuous and if the GDP decreases by 10% or more than it is called as a
Depression.

P
r
i
c
e

AS

E1

L
e
v
e
l

E2
AD 1
AD 2

Output/ Real GDP

DEFLATION refers to a sustained decrease in the general price level.


5

STAGFLATION was a term that was coined to describe the situation that emerged in the early
1970s. It combined the words stagnation and inflation to describe a phenomenon in which
economic growth stagnated while the rate of inflation increased. Economys aggregate supply
curve which normally moves outward from one year to the next shifts inward instead. When this
happens, real GDP declines as the price level rises.

AS 2

P
r
i
c
e

AS 1
E2

L
e
v
e
l

E1

AD

Output/ Real GDP

Economic Growth is a state in which economys growth is increasing, business increase


production, investing is increasing, unemployment rate is declining, Aggregate Demand for
goods and services will increase so also the Aggregate Supply. AS and AD curves will shift to the
right.

AS 1

P
r
i
c
e

AS 2

L
e
v
e
l
AD 2
AD 1

Output/ Real GDP

AS 1

P
r
i
c
e

AS 2

L
e
v
e
l
AD 2
AD 1

Output/ Real GDP