Introduction to Macroeconomics

T.J. Joseph

Contents
National Income Accounting Aggregate Demand and Aggregate Supply Macroeconomic Equilibrium Money and Banking Integration of Goods and Money Markets (IS-LM) Fiscal and Monetary Policies Business Cycles Inflation and Unemployment International Trade and Balance of Payments

Distribution of Marks
Component
Group Assignment Presentations News Analysis and Class participation Attendance Mid-Term Examination End-term Examination TOTAL

Marks 05 10 10 05 20 50 100

Introduction
Managers have to cope with economic environment at two levels (i) Firm level (Microeconomics)
Depend on market structure: More competitive market less influence on price reduce cost or differentiate product

(ii) Macro level (Macroeconomics)

Assumption of stability in demand, prices, interest rates, wages, taxes, and exchange rates.

Why to study Macroeconomics?

To understand the functioning of an economy
What causes fluctuations in demand? What leads to instability in interest rates, prices (inflation rates), exchange rates?

To understand the direction of govt. policies To take a decision on timing of fresh investments, takeovers, enter new markets, etc. To get best return on investment

Macroeconomic An Introduction
Macroeconomics study of the behavior and performance of the economy as a whole Study of factors or forces determining the level and growth of macroeconomic aggregates Macroeconomic aggregates (macroeconomic variables) output, income, employment, price level, balance of payment positions, etc. Aggregate behavior refers to the behavior of all households and firms together.

Concepts in Macroeconomic Analysis

Stock and Flow Variables
Stock: quantity of a variable at a point in time Eg: Capital stock, money supply, unemployment level, foreign exchange reserve, etc. Flow: quantity expressed for a period of time Eg: GDP, inflation, exports, consumption, etc.

Concepts in Macroeconomic Analysis

Aggregate Demand and Aggregate Supply
Aggregate Demand: sum of demands for all consumer goods and services and for capital goods Sum of consumption, investment, government expenditure and net export. Aggregate Supply: sum of the supplies of all consumer goods and services and of capital goods The amount of output the economy can produce given the resources and technology available

The Roots of Macroeconomics

The Great Depression was a period of severe economic contraction and high unemployment that began in 1929 and continued throughout the 1930s.
A recession is a period during which aggregate output declines. Two consecutive quarters of decrease in output signal a recession. A prolonged and deep recession becomes a depression.

The Roots of Macroeconomics

Classical economists applied microeconomic models, or market clearing models, to economy-wide problems Main argument: Supply creates its own demand - Say s law No intervention by the government (Laissez faire). Economy should be left to market forces ( invisible hand ) The failure of classical models to explain the prolonged existence of high unemployment during the Great Depression led to the development of macroeconomics

The Roots of Macroeconomics

In 1936, John Maynard Keynes published The General Theory of Employment, Interest, and Money. Keynes arguments:
The level of output and employment in an economy is determined by the aggregate demand (AD) Governments could intervene in the economy and affect the level of output and employment

Two important objectives of macroeconomic policies:

(a) Sustained growth in GDP, and (b) Price stability

Functions of an Economy
An economy is a complex arrangements of many different buyers and sellers households, businesses, government, and the rest of the world and of their interactions with each other An economy employs various resources to produce a variety of goods and services for domestic and world consumption, and provides income for the resources

Ref: MB p.91-92

The Components of the Macro Economy

An economy can be pictured as a schematic of closely linked sectors households, businesses, financial institutions, governments, and foreigners A change in one sector s transaction with another sector will trigger changes in the entire schematic The circular flow of income and output diagram shows the income received and payments made by each sector of the economy

Two-sectors Circular Flow

Income Labor, land, capital, entrepreneurship Factor Market Wages, rent, interest, profit Inputs for production

Households
Saving

Financial Sector

Investment

Business/ Firms

Goods & Services bought Spending

Product Market

Goods & Services sold

Revenue

Three-sectors Circular Flow

Factor Market Wages, rent, interest, profit

Direct taxes

Direct/Indirect taxes

Households

Government

Business/ Firms

Govt. expenditure (G)

Financial Market

Govt. expenditure (G) Saving = Investment (S=I) Consumption Spending (C)

Product Market

Four-sectors Circular Flow

Remittances Export of services

External Sector

Receipts from exports Payments for imports

Wages, rent, interest, profit Direct taxes Direct/Indirect taxes

Households

Government

Business/ Firms

Govt. expenditure (G)

Govt. expenditure (G)

Saving = Investment (S=I) Consumption Spending (C)

The Three Market Arenas

Households, firms, the government, and the rest of the world all interact in the goods-and-services, labor, and money markets.

Who create demand and supply in these markets?

eakages and Injections

Leakage/Withdrawal: is the amount that is set aside by the households, firms, and governments and is not spent on the domestically produced goods and services over a period of time They reduce the size of the circular flow
Ex: savings, taxes, imports

Injection/Addition: is the amount spent by households and firms in addition to their regular incomes and receipts Injections increase the size of the circular flow
Ex: investments, govt. expenditures, exports

NATIONAL INCOME ACCOUNTING

National Income
Concepts and Measurement

Why National Income Accounting?

 Provides common standards of measurement of the size of an economy  Helps to evaluate the economic condition of a country and to compare conditions across time and across countries

Ref: MB p.97

National Income Concepts

Different concepts of NI - The Criteria (i) Items included in or excluded from the NI concept (ii) Method of estimating NI Gross Domestic Product (GDP) The sum of market value of all final goods and services produced in a country during a specified period of time, generally one year.

GDP ! Qi Pi
Also called GDP at market prices (GDPMP)
Ref: MB p.100

National Income Concepts

Market values of final goods and services are taken
Includes net indirect taxes

Considers only final goods and services

Intermediate goods are excluded to avoid the problem of double-counting

Considers output produced in a year

The year of production, not the year of sale Inventory as such is not included, but changes in inventory* is considered
*Changes in

inventory count output that is produced but not sold in a given year
Ref: MB p.100

National Income Concepts

GDP at factor cost (GDPFC) is the sum of all factor payments (wages, interest, rent, profits and depreciation) GDPFC= GDPMP Net indirect taxes (Net indirect taxes = Indirect taxes Subsidies) Gross National Product (GNP) The concept of GNP is similar to GDP, but with a significant difference.
Ref: MB p.103, 105

GDP vs. GNP

GDP measures the total value of goods and services that are produced within a country s geographical borders
Example: An Indian MNC in China will actually contribute to Chinese GDP

GNP measures the total value of all final goods and services that a country s citizens produce regardless of where they produce them
Example: Profits of Indian MNCs earn in overseas market is included in India s GNP

GNP = GDP + NFIA (Net Factor Income from Abroad)

(NFIA=income earned by residents abroad income earned by nonresidents from our country)
Ref: MB p.105

National Income Concepts

Net National Product (NNP)
GNP included final consumer goods + capital goods Depreciation: part of capital goods that is used up or consumed in the process of production Usually covered under Gross Investment (Gross Investment = Net Investment + Replacement Investment/Depreciation) NNP = GNP Depreciation NNPFC = NI (the actual measure of National Income) Per Capita Income = (NNPFC = NI ) / Total Population
Ref: MB p.106

National Income Concepts

Personal Income (PI)
The sum of all kinds of income received by the individuals from all sources of income The share of NI actually received by the HH sector
Personal Income (PI) = National Income (NI)
Minus Plus
Income earned but not received (undistributed corporate profits, social security contributions by the HHs (PF, pension funds), etc.) + Income received but not earned now (transfer payments by business and govt. to HHs, dividend income, etc.)

Disposable Personal Income (DPI): the income at the

disposal of a person
DPI = PI Direct taxes
Ref: MB p.107

National Income Concepts

Nominal and Real GNP
GNP is estimated at current and constant prices Nominal GNP: market value of all final goods and services measured in current year prices Real GNP: market value of all final goods and services measured in the price of a base year (constant prices) Why do we estimate GNP at constant prices? How to convert the nominal (current) values into real (constant) values?
Ref: MB p.108

National Income Concepts

GNP Deflator
An index of price changes for goods and services included in GNP Used to deflate the nominal GNP to eliminate the price effect to find real GNP for any year Real GNP = Nominal GNP / GNP Deflator GNP Deflator = Nominal GNP / Real GNP x 100

National Income Accounting

GDP (Gross Domestic Product) (Rs. crore)
2006-07 2007-08 At current prices
Growth rate

2008-09

2009-10

2010-11

4283979 4947857 5582623PE 6550271QE 7877947AE

15.6 15.5 12.0 17.3 20.3

At 2004-05 prices
Growth rate

3564627 3893457 4162509PE 4493743QE 4879232AE

9.7 9.2 6.8 8.0 8.6

National Income Measurement

Measurement of NI - Methods
A complex process Product flows (Real flows) and Money flows (factor payments and payments for goods and services) Three approaches of measuring NI: Product Approach Factor Income Approach Expenditure Approach

Measurement of NI - Methods
The Product Method
Also known as Output Method or Value Added Method Either by valuing all the final goods and services during a year OR By aggregating the values imparted (value added) to the intermediate products at each stage of production (to avoid Double Counting)
(Value added is the difference between the value of output and the value of the intermediate goods used in the production of that output)
Ref: MB p.101

Measurement of NI - Methods
Method
Classification of output under various categories (15 sub-categories are currently used in India) Computation of gross value of output of each category by multiplying the output of each category by their respective market prices and adding them together OR by summing up the value added at each stage of production This gives GDP at market prices

Measurement of NI - Methods
Product Method An illustration
Sectors
Total value in Rupees Crores

Agriculture & allied activities plus plus equals plus equals Manufacturing industries Services & construction GDP at market prices Net factor income from abroad GNP at market prices

1000 3000 4000 8000 1000 9000

Measurement of NI - Methods
The Income Method
Also known as factor share method Sum of the incomes accruing to the basic factors of production used in producing the national products Rent + wages + interests + profits + depreciation = GDP at factor cost Plus net income from abroad = GNP at factor cost

Ref: MB p.105

Measurement of NI - Methods
Factor Income Method An illustration
Sectors Total value in Rupees Crores

Income from employment plus plus plus equals plus equals Gross profits of companies Gross profits of public sector Rent GDP at factor cost Net factor income from abroad GNP at factor cost

1000 2000 2000 2000 7000 1000 8000

Measurement of NI - Methods
The Expenditure Method
Measures NI at final expenditure stage Excluded all expenditure on intermediate goods Sum of all money spend by individuals, firms and government within a year = GDP at market prices (Y) =) Consumption (C) + Investment (I) + Government Expenditure (G) + Exports and factor income from abroad (X) - Imports and factor income paid abroad(M)

Y=C+I+G+X-M
Ref: MB p.103

Measurement of NI - Methods
Expenditure Method An illustration
Sectors Total value in Rupees Crores

Consumer expenditure (C) plus plus Gross business spending (investment) (I) Govt. expenditure (G)

2000 3000 2000 7000 3000 1000 9000

equals Domestic expenditure at market prices (C + I + G) plus minus Exports & factor income from abroad (X) Imports & factor income paid abroad (M)

equals GNP at market prices (C + I + G + X - M)

GDP Omissions
There are three types of omissions in the measurement of GDP
1) Activities that are not part of GDP by definition Transfer payments & gifts received, second-hand sales (except brokerage), increase in share prices, etc.. 2) Items left out because of measurement problem All non-market transactions, unorganized sector, income through illegal means (black money), etc.. 3) Items related to the welfare of the people Quality of life, distribution of income, environmental damages, etc..

Problems of measuring GNP

Determining what is final and what is not (problem of double counting) Evaluation of non-marketed goods and services Example: - The goods and services produced and consumed at home, that never enter the market place The services of housewives, women at HHs. Many economic activities by unorganized sector Black money, black market items, income from illegal activities and professions, etc. Does not consider certain factors affecting people s welfare (like income distribution, environmental damages)
Ref: MB p.100

Exercise - 1
The following information is extracted from the National Income Accounts of an economy for the year 2008-09
Particulars GNP at factor price Indirect taxes NDP at market prices NNP at market prices GNP at market prices Personal income taxes Corporate profit tax Retained profit Rs. In crore 95,000 14,000 1,00,422 1,00,000 1,07,000 10,000 6,500 30,000

Compute (a) the value of depreciation; (b) the value of net factor income from abroad; (c) the value of subsidies; (d) the value of NDP at factor cost; (e) the value of national income; (f) the value of personal income; and (g) the value of personal disposable income

Exercise - 2
The following information is extracted from the National Income Accounts of an economy for the year 2008-09
Particulars NNP at factor price Depreciation Subsidies Net Factor Income from abroad Indirect taxes Personal income taxes Corporate taxes Retained profit Rs. In crore 4,73,246 61,809 19,431 -6,833 87,043 9,759 7,300 6,758

Compute (a) the value of GNP at market price; (b) the value of NNP at market price; (c) the value of NDP at market prices; (d) the value of NDP at factor cost; (e) the value of GNP at factor cost; and (f) the value of personal disposable income

Web References for Data (India)

http://indiabudget.nic.in http://finmin.nic.in http://eaindustry.nic.in http://www.rbi.org.in http://planningcommission.nic.in http://mospi.nic.in

References
1. Chapter 4 & 5, Principles of Macroeconomics by Michael Melvin and William Boyes . 2. Chapters 1 & 2, Macroeconomic Policy Environment by Shyamal Roy. 3. Chapter 2, Macroeconomics by R. Dornbusch, S.Fischer, and R. Startz.