Macro Economics Revision
Macro Economics Revision
By- Parth Gupta- FPM Scholar(Public Policy & Economics Track), MDI
Fiscal policy refers to the use of government spending and taxation to influence
a country’s economic activity. It is a critical tool used by governments to manage
economic growth, control inflation, reduce unemployment, and stabilize the
economy. The government adjusts its fiscal policy depending on whether it wants
to stimulate or cool down the economy, with a focus on achieving
macroeconomic goals like sustainable growth and price stability.
• Time Lags: Implementing fiscal policy changes can take time due to the
legislative process, meaning they may not have an immediate effect when
needed.
• Debt and Deficit: Expansionary fiscal policy can lead to increased
government debt if financed through borrowing. Managing the balance
between stimulating the economy and maintaining sustainable debt levels
is often a delicate task.
• Political Constraints: Fiscal policy is often influenced by political
considerations, which can sometimes lead to suboptimal decision-making.
In summary, fiscal policy is a powerful tool for shaping economic outcomes, but
it must be used carefully to balance the competing goals of growth, stability, and
equity. The effectiveness of fiscal policy depends on timely implementation,
sound economic analysis, and fiscal discipline to avoid unintended consequences
like excessive debt or inflation.
1. Interest Payments:
o A significant portion of government revenue may be used to service
debt, i.e., pay interest. This reduces the amount available for other
essential government spending such as healthcare, education, and
infrastructure development.
2. Crowding Out Private Investment:
o Large public debt can lead to higher interest rates as the government
competes with the private sector for available funds. This makes
borrowing more expensive for businesses, potentially crowding out
private investments and slowing economic growth.
3. Debt Sustainability:
o If public debt grows faster than the economy, it may become
unsustainable. This means the government could struggle to meet
future debt obligations, leading to a risk of default or the need for
austerity measures.
4. Higher Taxes or Reduced Spending:
o To manage large public debt, governments may need to increase
taxes or cut public spending, both of which can have negative effects
on economic growth and public welfare.
5. Risk to Sovereign Credit Rating:
o A growing public debt can affect the country’s credit rating, making
it more expensive to borrow in the future. A downgrade in the
sovereign credit rating can increase borrowing costs and lead to
reduced investor confidence.
6. Inflationary Pressures:
o Governments might finance large debts by printing more money,
leading to inflation. This reduces the purchasing power of citizens
and erodes savings.
7. Reduced Flexibility in Fiscal Policy:
o With a large portion of revenue tied up in debt servicing,
governments have less flexibility to implement countercyclical
fiscal policies (such as stimulus packages) during economic
downturns or emergencies like pandemics.
Why Implicit Liabilities of the Government Are Also a Cause for Concern:
In summary, both large public debt and implicit liabilities represent significant
risks to a government’s financial health. While explicit debt is an immediate
concern due to interest obligations and borrowing costs, implicit liabilities pose
a longer-term risk that can burden future generations and undermine fiscal
sustainability.
Types of Deficits and Budget Bifurcation:
Types of Deficits:
1. Fiscal Deficit:
o The difference between the government’s total expenditure and its
total revenue (excluding borrowings).
o Formula: Fiscal Deficit = Total Expenditure - (Total Revenue -
Borrowings)
2. Revenue Deficit:
o Occurs when the government’s revenue expenditure exceeds its
revenue receipts.
o Formula: Revenue Deficit = Revenue Expenditure - Revenue
Receipts
o Indicates the shortfall in the government’s ability to meet day-to-day
expenses using revenue receipts.
3. Primary Deficit:
o The fiscal deficit minus interest payments on previous borrowings.
o Formula: Primary Deficit = Fiscal Deficit - Interest Payments
o This shows the current fiscal deficit without the burden of past debts.
4. Effective Revenue Deficit:
o Revenue deficit adjusted for grants given to states and other entities
for the creation of capital assets.
o Formula: Effective Revenue Deficit = Revenue Deficit - Grants
for Capital Assets
o Aims to show a better measure of deficit by considering productive
grants.
Budget Bifurcation:
A. Revenue Budget:
• Revenue Receipts:
o Tax Revenue: Income from taxes like income tax, GST, corporate
tax, etc.
o Non-Tax Revenue: Income from sources like interest, dividends,
profits from government enterprises, and fees.
• Revenue Expenditure:
o Expenditure required for the day-to-day functioning of the
government, such as salaries, subsidies, and interest payments.
o Does not create any capital assets or reduce liabilities.
B. Capital Budget:
• Capital Receipts:
o Receipts that create liabilities or reduce assets, such as loans,
disinvestment (sale of government assets), and recovery of loans.
• Capital Expenditure:
o Expenditure on the acquisition of assets like infrastructure, schools,
hospitals, etc.
o Leads to the creation of long-term assets or reduction of liabilities
o
• Recessionary Gap: This occurs when actual GDP is below potential GDP,
indicating that the economy is underperforming, with unemployment
above its natural rate.
• Expansionary Fiscal Policy: The government increases spending or
reduces taxes to stimulate demand and push the economy toward its full
potential. The goal is to close the output gap by boosting aggregate demand
(AD).
Steps:
• Inflationary Gap: This occurs when actual GDP exceeds potential GDP,
often leading to higher inflation as demand outpaces supply, and
unemployment is below its natural rate.
• Contractionary Fiscal Policy: The government reduces spending or raises
taxes to cool off excessive demand, aiming to bring the economy back to
its sustainable output level.
Steps:
The multiplier effects of changes in taxes and government transfers refer to the
impact these fiscal policy tools have on overall economic output through their
effects on aggregate demand. Both taxes and transfers affect the disposable
income of households, which in turn influences their spending behavior. Here’s
how the multiplier effects work for each:
1. Multiplier Effect of Changes in Taxes
Example:
• If the government reduces taxes by $100 and the MPC is 0.8, the tax
multiplier would
be:Tax Multiplier=−0.81−0.8=−4Tax Multiplier=−1−0.80.8=−4
• This means a $100 tax cut would increase aggregate demand by $400.
Transfers Multiplier:
• The multiplier for government transfers is similar to the tax multiplier but
tends to be higher in effect because transfer recipients are more likely to
spend most or all of the extra income.
Example:
• If the government increases transfers by $100 and the MPC is 0.8, the
transfer multiplier would
be:Transfers Multiplier=0.81−0.8=4Transfers Multiplier=1−0.80.8=4
• This means a $100 increase in transfers would raise aggregate demand by
$400.
Comparison:
• The government spending multiplier is typically larger than both the tax
and transfer multipliers because spending directly injects money into the
economy, while tax cuts or transfers rely on the recipients' decision to
spend.
• Tax cuts have a smaller multiplier effect than transfers because people
may save a portion of their tax savings, reducing the immediate impact on
aggregate demand.
• Transfers have a larger multiplier than taxes because they target
individuals with higher MPCs, who are more likely to spend the additional
income rather than save it.
In summary:
Economic Growth
Economic growth refers to the increase in a country’s output of goods and
services over time, measured by the growth of GDP. Sustained economic growth
leads to improvements in living standards.
Standard of Living
The standard of living reflects the level of wealth, comfort, material goods, and
necessities available to a population. It is influenced by GDP per capita, income
distribution, access to healthcare, education, and infrastructure.
.
Comparing Per Capita Income of Various Countries
Per Capita Income Comparison (2023)
Here is a bar graph comparing the per capita income of India with other countries
for 2023. It highlights the significant differences in income levels across
countries.
The Phillips Curve: The Unemployment-Inflation Trade-Off
The Phillips Curve represents the inverse relationship between unemployment
and inflation in the short run. It suggests that lower unemployment comes with
higher inflation, and higher unemployment comes with lower inflation. Here's an
explanation in points along with an example:
Key Points of the Phillips Curve:
1. Historical Observation:
o In the late 1950s, economist A.W. Phillips found a negative
relationship between unemployment and wage inflation in the UK.
This concept was later generalized to a relationship
between unemployment and price inflation.
2. Short-Run Phillips Curve:
o In the short run, a lower unemployment rate often leads to higher
inflation, as increased demand for goods and services pushes prices
up and labor markets tighten, raising wages.
o Conversely, higher unemployment is associated with lower
inflation because reduced demand for goods and services puts
downward pressure on prices, and wages stagnate due to excess
labor supply.
3. Trade-Off Between Unemployment and Inflation:
o Policymakers face a trade-off in the short run: reducing
unemployment can lead to higher inflation, while controlling
inflation can result in higher unemployment.
4. Shifts in the Phillips Curve:
o The Short-Run Phillips Curve (SRPC) can shift due to changes in
expectations of inflation (i.e., if people expect higher inflation, they
demand higher wages).
o Supply shocks (like oil price increases) can also shift the curve,
leading to stagflation—a situation where both unemployment and
inflation rise.
5. Long-Run Phillips Curve:
o In the long run, the Phillips Curve is vertical at the natural rate of
unemployment (also called the NAIRU: Non-Accelerating
Inflation Rate of Unemployment).
o Over time, inflation expectations adjust, and there is no trade-off
between unemployment and inflation in the long run. Attempting to
push unemployment below its natural rate will only cause
accelerating inflation without reducing unemployment further.
Diagram:
Here’s a diagram showing the Phillips Curve:
Short-Run Phillips Curve (SRPC) and Long-Run Phillips Curve (LRPC)
1. SRPC: A downward-sloping curve showing the trade-off between inflation
and unemployment in the short run.
2. LRPC: A vertical line at the natural rate of unemployment, showing that
in the long run, there is no trade-off.
Let me plot it visually.
Here is a diagram illustrating the Phillips Curve:
• The Short-Run Phillips Curve (SRPC) shows the inverse relationship
between unemployment and inflation. As unemployment decreases,
inflation increases (and vice versa).
• The Long-Run Phillips Curve (LRPC) is vertical at the natural rate of
unemployment, indicating that in the long run, no trade-off exists between
inflation and unemployment.
Example:
• If the economy is operating at a low unemployment rate (e.g., 4%),
inflation will likely be higher, as businesses need to raise wages to attract
workers, leading to higher prices.
• Conversely, if unemployment rises to 8%, inflation will likely fall, as there
is less demand for goods, reducing upward pressure on prices.
The natural rate of unemployment (here at 6%) represents a balance where
inflation is stable in the long run. Attempts to push unemployment below this rate
may lead to accelerating inflation without sustainable job growth.
Employment
Employment refers to the condition of having paid work. It includes individuals
who are engaged in productive activities that earn them wages, salaries, or self-
employment income. An employed person contributes to the economy by
producing goods or services.
Example:
A person working as a teacher, factory worker, or software developer is
considered employed as they are earning an income for their work.
Unemployment
Unemployment occurs when individuals who are capable and willing to work
cannot find a job despite actively searching for one. Unemployment can arise due
to various reasons such as economic downturns, technological changes, or
structural shifts in the economy.
Types of Unemployment:
1. Frictional Unemployment: Short-term unemployment that occurs when
people are between jobs or entering the labor market.
2. Structural Unemployment: When there is a mismatch between the skills
workers possess and the jobs available.
3. Cyclical Unemployment: Caused by downturns in the economy, like
during a recession.
4. Seasonal Unemployment: Related to industries with seasonal patterns
(e.g., agriculture, tourism).
Example:
A person who loses their job due to company downsizing or someone who cannot
find a job after graduating from college is considered unemployed.
Labor Force
Labor Force includes all individuals who are of working age and are either
employed or actively seeking employment. It consists of both the employed and
the unemployed who are actively looking for jobs. People who are neither
working nor looking for work, such as retirees or students, are not considered part
of the labor force.
Example:
A country's labor force includes both those who have jobs and those who are
unemployed but are actively searching for work.
Key Formula:
Labor Force = Employed + Unemployed (actively s eeking work)
1. Worker Population Ratio (WPR)
The Worker Population Ratio measures the proportion of a country's working-
age population that is employed.
2. Labor Force Participation Rate (LFPR)
The Labor Force Participation Rate indicates the proportion of the working-age
population that is either employed or actively seeking employment.
3. Unemployment Rate
The Unemployment Rate measures the percentage of the labor force that is
unemployed and actively looking for work.
Aggregate Demand
Aggregate Demand (AD) is the total quantity of goods and services demanded
in an economy at various price levels in a given period. It consists of the sum of
consumption (C), investment (I), government spending (G), and net exports
(NX):
AD=C+I+G+(X−M)AD=C+I+G+(X−M)
Aggregate demand shows the relationship between the price level and the
quantity of output demanded, reflecting the demand for real GDP.
o .
2. Savings Function: The savings function is the opposite of the consumption
function. Since households either consume or save, the Marginal
Propensity to Save (MPS) is the complement of MPC.
o S = Y – C Or S = –a + (I – b) Y
o If MPC = 0.8, then MPS = 0.2, meaning 20% of additional income
will be saved.
Aggregate Demand and Keynesian Multiplier
• Aggregate Demand: According to Keynes, consumption is the most
important component of aggregate demand (AD). AD = C + I + G + (X -
M), where:
o CCC = Consumption
o III = Investment
o GGG = Government spending
o X−MX - MX−M = Net exports (exports minus imports)
• Keynesian Multiplier: The Keynesian multiplier effect states that an
initial increase in spending (such as government expenditure) leads to a
larger increase in overall economic output. The multiplier is determined by
MPC.
1. Measures the effect of changes in spending on overall economic output.
This framework emphasizes the role of consumption in driving aggregate demand
and economic activity, especially in times of economic downturns when
government intervention can help boost demand.
Investment Spending
Investment spending refers to the expenditure made by firms on capital goods
such as machinery, equipment, factories, and infrastructure, which are used to
produce goods and services. Investment spending is a key component of
aggregate demand and plays a vital role in influencing economic growth.
In the context of macroeconomics, investment spending includes two types:
1. Planned Investment: The investments firms intend to make.
2. Unplanned Investment: Changes in inventories that result from
unexpected fluctuations in demand.
Planned Investment Spending
Planned investment spending refers to the investment that businesses intend to
make during a specific period. This includes expenditures on new capital goods
like machinery, equipment, factories, and research and development. Planned
investment spending is a deliberate decision by firms based on future expectations
of profits, economic conditions, and demand for their products.
Factors Affecting Planned Investment Spending:
1. Positively Dependent Factors (Increase Investment Spending):
o Expected Future Profits: If firms expect higher future profits due
to rising demand, they are more likely to invest in expanding
production capacities.
§ Example: A car manufacturer investing in a new factory
based on an expected surge in car demand.
o Business Confidence: When firms are optimistic about the
economy's growth and stability, they tend to increase planned
investment.
o Government Policies: Tax incentives, subsidies, and lower
corporate taxes encourage higher investment spending.
o Technological Advances: Innovations that make production more
efficient encourage firms to invest in new equipment and
technologies.
o Positive Economic Growth: When the overall economy is growing,
firms invest to capitalize on increasing consumer demand.
2. Negatively Dependent Factors (Decrease Investment Spending):
o Interest Rates: Investment spending is negatively related to interest
rates. Higher interest rates increase the cost of borrowing, making it
more expensive for firms to finance investments.
§ Example: A firm may cancel plans to build a new factory if
borrowing costs are too high.
o Economic Uncertainty: In times of economic uncertainty or
instability, firms may delay or reduce investment due to fear of
potential losses.
o Higher Operating Costs: Increases in the cost of inputs (e.g., raw
materials, wages, and energy) can reduce the incentive to invest, as
it reduces expected returns.
o Taxation: Higher corporate taxes or unfavorable regulatory
conditions can deter investment spending.
Inventory Investment and Unplanned Inventory Investment
1. Inventory Investment:
o Definition: Inventory investment refers to the change in the stock of
unsold goods that firms hold during a certain period. Firms may
intentionally build up inventories in anticipation of future sales, or
they may reduce inventories when demand slows down.
o Planned Inventory Investment: Firms often plan for certain levels
of inventory to meet expected demand. This is the inventory that
firms intend to hold to ensure smooth operations and avoid
stockouts.
§ Example: A retailer may increase its inventory in preparation
for the holiday shopping season.
2. Unplanned Inventory Investment:
o Definition: Unplanned inventory investment occurs when there is a
discrepancy between actual sales and expected sales. If demand for
goods is lower than expected, firms accumulate excess unsold
goods, leading to unplanned increases in inventory.
o Unplanned Inventory Build-Up: If firms overestimate demand,
they end up with more inventory than expected.
§ Example: A car manufacturer producing more cars than it
sells ends up with unplanned inventory.
o Unplanned Inventory Depletion: If demand exceeds expectations,
firms may sell more goods than they have planned for, leading to an
unplanned reduction in inventory.
§ Example: A retailer may face a stock shortage during a major
sale event, indicating unplanned depletion of inventory.
Unplanned and Planned Investment Spending
Planned investment spending is the portion of investment that firms
intentionally undertake, such as building factories, purchasing machinery, or
increasing inventory levels based on anticipated demand. Planned investment can
be influenced by expectations of future economic conditions, costs of financing,
and other factors as mentioned earlier.
Unplanned investment spending occurs when there is an unexpected change in
demand or sales, resulting in changes in inventory levels. Unplanned investment
can be positive (an unplanned increase in inventory) or negative (an unplanned
depletion of inventory).
• Positive Unplanned Investment: When firms produce more than is sold,
leading to an increase in inventory. This represents unintended investment
in goods that were not sold.
o Example: A shoe manufacturer producing more shoes than
consumers purchase, causing a build-up of unsold shoes in stock.
• Negative Unplanned Investment: When firms sell more than they have
in stock, leading to a reduction in inventory. This results in an unplanned
drawdown of inventory.
o Example: A toy company facing unexpectedly high sales during the
holiday season and running out of stock.
Summary of Investment Spending
1. Planned Investment Spending: Investment that firms intend to make
based on future expectations and factors like profits, interest rates, and
government policies.
2. Unplanned Investment Spending: Changes in inventory levels due to
unexpected fluctuations in demand.
3. Inventory Investment: Refers to the changes in the stock of goods that
firms hold, including both planned and unplanned inventory changes.
4. Link Between Planned and Unplanned Investment: When firms
misjudge demand, unplanned changes in inventory serve as a buffer,
leading to either positive or negative unplanned investment.
Understanding both planned and unplanned investment spending is essential for
evaluating how firms react to changing economic conditions and how these
reactions influence aggregate demand and overall economic activity.
The Income-Expenditure Model is a key concept in Keynesian economics that
illustrates how the equilibrium level of national income (GDP) is determined by
the total spending or aggregate demand in an economy. The model is also called
the Keynesian Cross.
Here's a simple breakdown of the model:
Key Components:
1. Consumption (C): The amount of income households spend on goods and
services.
2. Investment (I): The spending by firms on capital goods like machinery
and infrastructure.
3. Government Spending (G): The spending by the government on goods
and services.
4. Net Exports (NX): The difference between exports and imports.
The total of these components forms the Aggregate Expenditure (AE):
AE=C+I+G+NX
Equilibrium:
In the model, equilibrium occurs when Aggregate Expenditure
(AE) equals Total Output (Y), i.e., the economy produces just enough goods and
services to meet the overall demand.
AE=Y
If AE is greater than Y, there's an increase in production to meet demand, leading
to economic growth. If AE is less than Y, it results in a decline in production and
potentially a recession.
Graphical Representation (Keynesian Cross):
• 45-degree line: Represents all points where output (Y) equals spending
(AE).
• AE curve: Represents the planned expenditure at each level of income.
Where the AE curve intersects the 45-degree line is the equilibrium output.