MACROECONOMICS

Introduction
Economics?
Economics is the social science that studies
economic activity to gain an understanding
of the processes that govern the production,
distribution and consumption of goods and
services in an economy.
Positive vs. Normative
Branches- Micro, Macro..
Types of Economies (factors of production)
Closed & Open economy

What Economics Is All About

Scarcity: Unlimited needs, limited resources
Requirement of optimization
Trade-offs involved

Economics: the study of how society manages

its scarce resources, e.g.
how people decide what to buy,
how much to work, save, and spend
how firms decide how much to produce,
how many workers to hire
how society decides how to divide its resources
between national defense, consumer goods, protecting
the environment, and other needs

Basic Problems
Basic Problems of economy
Problem of choice
What, How & For Whom (Production,
Allocation, Distribution)

Opportunity Cost
Best possible trade-off

PPF

PPF
Points on the curve- Productive
Efficiency
Points inside the curve- Productive
inefficiency
Allocative Efficiency- is a type of
economic efficiency in which
economy/producers produce only
those types of goods and services
that are more desirable in the society
and also in high demand.

Micro
Microeconomics deals with individual
economic agents/ variables and their
interaction.
Consumption (Marginal Utility)
Demand Side

Production (Process, factors of production)

Supply Side

Equilibrium
Markets (Types)

Elasticity
Responsiveness of one variable to
changes in the other variable.
Price elasticity
Income elasticity.......

Perfectly elastic, Elastic, Unitary

elastic and Inelastic DD & SS
Relatively elastic/ inelastic degree
of responsiveness

Euilibrium

Macro
Macroeconomics deals with aggregate
economic variables and their
interlinkages
Study of aggregates (Y, P, M)
Goals (Price Stability, Full Employment,
Economic Growth & Development, Self
Reliance)
Tools ( Fiscal, Monetary and Trade Policy)

Pre & Post 1930s

Pre 1930s
Prevalence of Micro

Full wage-price flexibility

Full employment output and equilibrium
Thus no idle resources
Fully competitive markets
Changes in Y only through re-allocation of
resources
Thus only problem of optimal allocation of
resources

Contd..
Post 1930
Emergence of Macro
Great Depression
It was realized that Y may not be at Yf
Resources may be idle- UN
Problem not of allocation but of Utilization
of resources
Yf is one of the many possible levels of Y
that can be there.
Level of Y determined by AD

Income & Product

For 1 Re worth of Product 1 Re
worth of income is generated.
Value of all products (goods &
services) Incomes generated in
production of products
Value of products measured by:
VA method or
Expenditure Method

The Circular-Flow Diagram

Economy
Producers
Consumers

Goods
Consumption goods
Capital goods

Services

Circular Flow of Income & Product

Firms

Households:
Households:
Own
Own the
the factors
factors of
of production,
production,
sell/rent
sell/rent them
them to
to firms
firms for
for
income
income
Buy
Buy and
and consume
consume goods
goods &
&
services
services
Household
s

Firms:
Firms:
Buy/hire
Buy/hire factors
factors of
of
production,
production,
use
use them
them to
to produce
produce
goods
goods and
and services
services
Sell
Sell goods
goods &
& services
services

Circular flow of Income

(with the assumption of No G, T, X, M, S or I)

Circular flow of Income

(with G, T, X, M, S, I)

Wages, rents, interest,

profits

Factor services

FIRMS

HOUSEHOLDS

Goods
Taxes
Savin
gs

Imp
ort
s

Government
Financial markets
Personal consumption
Other countries

en t
m
n
r
e
Gov nding
Spe
ent
m
t
s
e
v
In
rts
Expo

Measurement

Total value of
goods &
services
produced
(Product
Method or
Value Added
Method)

Total
Expenditure
on goods &
services
(Expenditure
Method)

Total factor
income
(Income
Method)

Measurement
Value Added Method
GVA = (cost of goods produced)-(cost of
intermediate goods used in production)
GVA = GDP
(at Market Price)
MP

Expenditure Method (2 sector)

Y=C+I
( Expenditure on Consumption goods
and Investment goods)

Income Method
Y = w+r+i+p = C + S ( Income received is either
consumed or saved)

NI? Economic Growth?

Measurement
Expenditure Method- Exclusions

Intermediate goods
Expenditure pertaining to other periods
Transfer Payments
Depreciation

Final Output= C + I + inventories = GDP

MP

Income Method
Current period
For goods and services produced
Excludes Capital receipts and Transfer payment
receipts

THE EXPENDITURE APPROACH

Economists and policy makers are not only
interested in the total production but also
in the allocation of expenditure between
alternative uses. The national income
accounts identity divides total expenditure
into four broad heads: consumption C,
investment I, government expenditures G,
and net exports NX.
Y = AD = AE = C+I+G+NX
Y is GDP
NX = X-M (Exports less imports)

THE EXPENDITURE APPROACH

The expenditure approach is the bottom half of
the circular flow
Consumption: households and individuals
receive income and spend them on domestic,
as well as, foreign goods and services, and pay
taxes. They also save what is not consumed
It is the largest and most important of the
flows, the most obvious way income received
is returned to firms
We aggregate all kinds of goods: durable
goods, non durable goods and services

THE EXPENDITURE APPROACH

The portion of income saved leaves the
circular flow and enters financial markets
Investment: it is the business spending on
equipment (business fixed investment),
structures (residential fixed investment) and
inventories (can be negative)
Investment is for future use
Depreciation is the erosion of the value of
assets in creating output: the wear and tear
Net
investment=gross
investment
less
depreciation (depreciation is sometimes
called capital consumption allowance, CCA)

THE EXPENDITURE APPROACH

Government expenditures: government
makes payments for buying and using
goods and services as well as equipments
and structures
Taxes are either spent or returned to
individuals as transfers
If the government runs a deficit then it
must borrow from financial markets to
close the gap

THE EXPENDITURE APPROACH

Net exports: exports are foreigners
demand for our goods and hence
contributes to our income
Imports are subtracted from spending by
consumers, investors and government, as
they are a leakage from the domestic
economy, contributing to income for other
countries
Net exports is exports minus imports

NATIONAL INCOME (NY)

AND DISPOSABLE INCOME (DY) GRAPHICAL
REPRESENTATION

Net exports (X) Depreciation

GNP
at
mar
ket
price

Government
Expenditure on Indirect Taxes
Goods &
Services (G)
Gross Private
Investment (I) NNP at factor

cost
Private
Consumption
(C)

or
The National
Income
(NY)

Direct Taxes
Net Business
Savings

Transfer
Payments

DY

PI & PDI
Personal Income (PI):
This measures all of the income that is received by individuals, but not
necessarily earned. Examples of this include social security benefits,
unemployment compensation, welfare payments, benefits for veterans,
and food stamps. Individuals also contribute income which they do not
receive. This includes corporate profits that are undistributed, indirect
business taxes, and the contribution of employers to Social Security.
PI = NI + income received but not earned - income earned but
not received.
Personal Disposable Income (PDI) = PI - Personal Income Taxes

Output & Employment

Classical Model
Supply Side
Output and employment at Yf level
Wages prices fully flexible upto Yf level
AS curve fully inelastic at Yf level

Contd.
Demand Side
AD
MV = PY (QTM)

V, Y given
PM
Given M, MV is given => DD is Unitary Elastic
P is determined

Equilibrium level of Y
Intersection of AD & AS

AS
P

AD

Yf

Contd.
Classical model for r
Savings is a direct function of r
r is seen as a return for foregoing present
consumption and saving

Investment is an inverse function of r

r is viewed as the cost of borrowing funds
for investment

Equilibrium r determined by the

intersection of S & I curves.

Keynesian Model
Supply side
Wages and prices are rigid downwards
Perfectly elastic or upward sloping AS
curve upto Yf level then becomes
Inelastic

Demand side
Y dependent on AD
AD = C + I + G + (X-M) = C + S

Keynesian Model
Consumption function

Function of Disposable Income (Y-T+R)

MPC, MPS
G & I autonomous
Taxes can be Lump sum or an increasing function of
Y, MPT

Trade (X-M), X is exogenously determined ,

M is a direct function of Y, MPM

Equilibrium
Multipliers

AGGREGATE DEMAND AND AGGREGATE

SUPPLY IN THE LONG RUN AND VERY
LONG RUN
Price level P
AS

All factors are fully employed.

Hence any increase in demand
will lead to a price adjustment
only, with no change in output
the Classical Model

Unless, of course, the productiv

capacity of the economy rises
by shifting the AS to the right
through (accumulation of
capital) economic growth
AD
Income, Output Y

 The Medium and Short Run

The aggregate demand AD and
aggregate supply AS (of the entire
economy) together determine output,
prices, and employment
Fluctuations are analyzed and policies
prescribed to best utilize existing
factors of production
Prices are considered (on the basis of
observations and economic
reasoning) to be sticky and rigid
(slow to adjust)

AGGREAGATE DEMAND AND

AGGREGATE SUPPLY IN THE
MEDIUM RUN
Price Level P

AS
Wages
are rigid downward
Prices and quantities
are both relatively flexible.
When AD shifts,
both prices and
quantities adjust

AD
Income and Output Y

AGGREGATE DEMAND AND

AGGREGATE SUPPLY IN THE
SHORT
RUN
Price Level P

Factors of production not

fully employed. Wages and
prices are fully rigid. Level of
demand determines
quantities Keynes approach

AS

AD
Income and Output
Y

Money
Money
Medium of exchange
Unit of account
Store of value

Full Bodied vs. Token Money

Fiat Money- Legal Tender

Measuring the Money Stock In

India
Money supply is controlled by the central
bank of an economy (RBI in India)
Measuring money is always somewhat
arbitrary to the extent what should be
included as money and what should not be
Measures vary (marginally from country to
country)
We will look at the money stock measures
of RBI in India

Measures of Money
M0 (Reserve Money or High Powered
Money H): Currency in circulation +
Bankers deposits with the RBI + Other
deposits with the RBI
= Net RBI credit to the Government + RBI
credit to the commercial sector + RBIs
claims on banks + RBIs net foreign assets +
Governments currency liabilities to the
public RBIs net non-monetary liabilities.
M1 (Narrow Money): Currency with the
public + Deposit money of the public
(Demand deposits with the banking system +
Other deposits with the RBI)

Measures of Money
M2: M1 + Savings deposits with Post office savings
banks.
M3 (Broad Money OR Aggregate Monetary
Resources AMR):
M1+ Time deposits with the
banking system
= Net bank credit to the Government + Bank credit
to the commercial sector + Net foreign exchange
assets of the banking sector + Governments currency
liabilities to the public Net non-monetary liabilities of
the banking sector (Other than Time Deposits).
M4:
M3 + All deposits with post office savings
banks (excluding National Savings Certificates)

RBI Balance Sheet

Liability (uses)
Currency:

Assets (sources)
Gold

i) Held By Public

Forex

ii) Vault cash of Banks

Loan to GoI

Deposit of Commercial Banks

with RBI

Loan to Commercial Banks

Treasury Deposits of GoI

Monetary Base (Uses)

Monetary Base (Sources)

THE RBI's CONSOLIDATED

BALANCE SHEET
LIABILITIES
1. Monetary
liabilities
2. Net nonmonetary
liabilities

ASSETS
3. Net foreign
exchange assets
4. Net RBI credit
to government
5. Credit to
commercial sector
High powered money is 3+4+5-2

BANKING SYSTEMs
CONSOLIDATED
B-SHEET

LIABILITIES
1. Monetary
liabilities
2. Net nonmonetary
liabilities

ASSETS
3. Net foreign
exchange assets
of banks
4. Net bank credit
to government
5. Commercial
Broad Money is the monetary
credit liability of
banking system

H=C+R
M=C+D
D = DD + TD
c= C/DD => C = cDD
t= TD/DD => TD = tDD
r= R/D => R = rD = r(DD + TD) =
r(1+t)DD
Money Supply (M) = m.H
m= M/H = (1+c+t)DD/[c+r(1+t)DD]

Money Market
Keynesian Theory
Demand
Transaction Demand
Directly related to Income (Y)
Mt = k (PY) OR Mt/P = k (Y) OR mt = k. Y

Speculative
Inversely related to rate of interest (r)
If (r) increases, bond prices to fall
msp = h(r)

md = mt + msp

Supply
Ms Total stock of money in circulation among public at a
particular point in time

IS- LM
Simultaneous equilibrium of
Goods Market
Points of equilibrium in Goods market lie on
the IS curve
IS f (r, Y)

Money Market
All points of equilibrium in Money Market lie
along the LM curve
LM g (r, Y)

S > I Y will
fall
ms > md r
will fall

LM

S > I Y will fall

md > ms r will
rise

I > S Y will
rise
ms > md r
will fall
I > S Y will
rise
md > ms r
will rise

IS

Inflation
Demand Pull
Cost Push
Philips curve

Demand Pull
Inflation

Cost push
inflation

Business Cycles
Inflationary Gap and Deflationary
Gap

BoP
Record of International transactions
of a country with RoW over a given
period of time
Double entry book keeping
Equilibrium?

BoP
Credits

R
s

Debits

1 Exports of goods

Import of goods

2 Exports of services
(shipping, tourism,
banking, insurance, etc.)

Import of services
(shipping, tourism,
banking, insurance, etc.)

3 Unrequited receipts (gifts,

remittances, grants etc.
from foreigners)

Unrequited payments
(gifts, remittances,
grants etc. to foreigners)

4 Capital receipts
(borrowings from, capital
repayments by, sale of
assets to, foreigners)

Capital payments
(lending to, capital
repayments to, purchase
of assets from,
foreigners)

TOTAL RECEIPTS
TOTAL PAYMENTS
4 is basically import of capital (brings forex)
8 is export of capital (outgo of forex)

R
s

BoP
A

Balance of Trade

1-5

Balance of services

2-6

Balance of unrequited transfers

3-7

BALANCE OF CURRENT ACCOUNT

A+B+C

BALANCE OF CAPITAL ACCOUNT

4-8

BALANCE OF PAYMENTS

D+E

Does it Balance?

Exchange Rate

Fixed
Floating
Devaluation?
Depreciation?
RER