Introduction to Macroeconomics

• Macroeconomics focuses on the determinants of total

national output. Macroeconomics studies not household
income but national income, not individual prices but the
overall price level.
• It does not analyze the demand for labor in the automobile
industry but instead total employment in the economy
• Microeconomics deals with individual decisions;
macroeconomics deals with the sum of these individual
decisions. Aggregate is used in macroeconomics to refer to
sums. When we speak of aggregate behavior we mean the
behavior of all households and firms together.
• aggregate behavior: The behavior of all households and
firms together
 INTRODUCTION - MACROECONOMIC ISSUES AND
MEASUREMENT

What is Macroeconomics
• Macroeconomics is about the economy as a whole. It studies
aggregate phenomena, such as business cycles, living
standards, inflation, unemployment, and the balance of
payments. It also asks how governments can use their
monetary and fiscal policy instruments to help stabilize the
economy.
 INTRODUCTION - MACROECONOMIC ISSUES AND
MEASUREMENT

Why do We Need Macroeconomics

• Macroeconomics is useful because it enables us to study
events that affect the economy as a whole without getting into
too much detail about specific products and sectors.
 Major Macroeconomic Issues

• Economic Growth
• Business Cycles
• Productivity
• Inflation
• Unemployment
• Government budget deficits
• Interest rates
• Targets and Instruments
• Economic growth: Both total and per capita
output have risen on average for many decades
in most industrial countries. These long term
trends give rise to high living standards for the
people.
• Long term growth is the predominant
determinant of living standards
 Business cycles

• The economy tends to move in a series of ups

and downs, called business cycles.
• During recessions- businesses go bust, profits
fall.
• During boom- demand for most products rises,
profits rise and most businesses find it easy to
expand.
 Productivity
• Economic growth can be achieved either by using
more inputs, such as increased capital or number of
workers, or by getting more output for any given
amount of inputs. – known as productivity growth.
• Central target of many govts in the first decade of
the twenty-first century- “raising the sustainable rate
of productivity growth, through reforms that
promote enterprise and competition, enhance
flexibility that promote enterprise and competition,
enhance flexibility and promote science, innovation
and skills”. – supply side policies
 Inflation
• Swings in economic activity have usually accompanied
swings in inflation.
• Attempts by govt. to control high inflation have tended to
bring about recessions
• However, slowdown in major economies in 2000-02 was
accompanied by very low levels of inflation.
• During 2003-08, major economies exhibited fast growth, but
then increases in prices of energy and other commodities
were associated with a rise in inflation.
• How to stimulate economic activity without causing inflation.
• During boom times- rise in inflation- led policymakers to
raise interest rates or taxes
 Unemployment
• A recession in economic activity causes an
increase in unemployment.
• Main method of reducing aggregate
unemployment that economists developed
early in the 20th Century was for govts to
increase their spending and reduce taxes
(Fiscal Policy).
 Government Budget Deficits
• Government spending more than taxes-
deficits.
• Deficits have to be financed by government
borrowing. If this is from the public, it raises
the national debt.
• If it is from the Central Bank, it is inflationary.
 Interest rates
• Monetary policy involves changing interest rates in order to
influence the economy.
• High interest rates are a symptom of a tight monetary policy.
• High interest rates- firms find costly to borrow- investments decline
• Individuals with mortgages or bank loans are also hit by high interest
rates since it costs more to make their loan repayments.
• High interest rates tend to reduce demand in the economy.
• Low interest rates tend to stimulate demand, but in 2008-10
recession, interest rates were so low that they could go no lower.
• Accordingly, monetary authorities adopted a new method called as
quantitative easing.
• This involved the central bank buying large amounts of government
bonds in order to increase the money supply.
• Another important channel of monetary policy is
via the exchange rate.
• Exchange rate changes affect the relative prices,
and thereby the competitiveness of domestic and
foreign producers.
• A significant rise in the cost of buying domestic
currency on the foreign exchange market makes
domestic goods expensive relative to foreign goods.
• This leads to a shift of demand away from domestic
goods towards foreign goods.
 Targets and instruments
• Outcomes- living standards, unemployment,
business cycles and inflation
• High living standards, high employment, low
unemployment, avoidance of recessions and
inflation- targets
• Instruments- Fiscal and Monetary Polices
(government spending, taxes, interest rates and
money supply)
• Instruments are variables that the govt can
change directly, in order to change the targets.
• The macro economic policy problem is to
choose appropriate values of the policy
instruments in order to achieve the best
possible combination of the outcomes of the
targets.
• This is a continually changing problem
because the targets are perpetually being
affected by shocks from various parts of the
world economy.
 INTRODUCTION - MACROECONOMIC ISSUES AND
MEASUREMENT

Economic growth is about the long-term trend in GDP.

The GDP gap

• Potential GDP is the level of national output that would be
produced if the economy were operating at its normal capacity,
of full-employment level.
• The GDP gap is the difference between actual GDP and its
potential level.
 INTRODUCTION - MACROECONOMIC ISSUES AND
MEASUREMENT

Measurement of National Output

• Each firm’s contribution to total output is equal to its value
added, which is the gross value of the firm’s output minus the
value of all intermediate goods and services - that is, the
outputs of other firms - that it uses.
• Goods that count as part of the economy’s output are called
final goods; all others are called intermediate goods. The sum
of all the values added produced in an economy is called gross
value added at basic prices. Basic prices are the prices received
by producers net of taxes on products [plus subsidies].
 INTRODUCTION - MACROECONOMIC ISSUES AND
MEASUREMENT

Measurement of National Output

• Goods that count as part of the economy’s output are called
final goods; all others are called intermediate goods. The sum
of all the values added produced in an economy is called gross
value added at basic prices. Basic prices are the prices received
by producers net of taxes on products [plus subsidies].
 INTRODUCTION - MACROECONOMIC ISSUES AND MEASUREMENT

Measurement of National Output

• Each firm’s contribution to total output is equal to its value
added, which is the gross value of the firm’s output minus the
value of all intermediate goods and services - that is, the
outputs of other firms - that it uses.
 Macroeconomic Concerns

• Three of the major concerns of Macroeconomics are

• Output growth
• Unemployment
• Inflation and deflation
• business cycle: The cycle of short-term ups and downs in the economy.
• aggregate output The total quantity of goods and services produced in an
economy in a given period.
• 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.
• 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.
• The unemployment rate—the percentage of the labor force
that is unemployed—is a key indicator of the economy’s
health.
• Inflation: An increase in the overall price level.
• Hyperinflation: A period of very rapid increases in the
overall price level.
• Deflation: A decrease in the overall price level.
Components of the Macro economy
• The term aggregate demand represents the total level of
spending on the goods and services produced within
the country over a given time period.
• It consists of four elements: consumer spending on
domestically produced goods and services (C),
investment expenditure within the country by firms,
whether on plant and equipment or on building up
stocks (I), government spending on goods and services
(such as health, education and transport) (G) and the
expenditure by residents abroad on this country’s
exports (X)
• Thus AD = C + I + G + X
 The inner flow, withdrawals and injections

• C = direct flow of money payments from

households to firms
• Withdrawals or leakages: Incomes of
households or firms that are not passed on
round the inner flow. Withdrawals equal net
saving (S) plus net taxes (T) plus import
expenditure (M)
• W = S + T+ M
 Injections
• Expenditure on the production of domestic
firms coming from outside the inner flow of
the circular flow of income. Injections equal
investment (I) plus government expenditure
(G) plus expenditure on exports (X).
• J=I+G+X
• Relationship between withdrawals and
injections
• S = I or G = T or M = X
 Economic Growth
• If injections exceed withdrawals, the level of
expenditure will rise. The extra spending will
generate extra incomes. In other words, GDP
will rise. There will be economic growth.
• This economic growth- tend to reduce
unemployment as firms take on more labor to
meet the extra demand.
• However, it leads to rise in inflation as the extra
demand drives up the price of goods and services
more rapidly than would have been the case.
• If planned injections are less than planned withdrawals then the
opposite of each of the above will occur. GDP will fall (there will
be negative economic growth); unemployment will rise and
inflation will fall.
• Assume there is a rise in injections- firms decide to invest more.
Aggregate demand (c + I) will be higher. Firms will use more labor
and other resources and thus pay out more incomes to hhs. Hhs
will respond to this by consuming more and so firms will sell
more.
• Firms will respond to this by producing more, and thus using still
more labor and other resources.
• Hhs income will rise again. Consumption and hence production
will rise again, and so on. There will thus be a multiplied rise in
GDP and employment. This is known as the multiplier effect.
 National Income

• National Income: National income of a country can be

defined as the total market value of all final goods and
services produced in the economy in a year.
• It is a monetary measure
• To judge whether economy is doing well, it is necessary
to look at the total income that everyone in the economy
is earning.
• GDP measures two things at once: total income of
everyone in the economy and the total expenditure on the
economy’s output of goods and services.
• For a economy as a whole, income must equal
expenditure
• GDP equals the total amount spent by
households in the market for goods and services.
• It also equals the total wages, rent and profit
paid by firms in the markets for the factors of
production.
• Money continuously flows from households to
firms and then back to households.
• All expenditure in the economy ends up as
someone’s income.
 Measurement of GDP

• GDP is the market value of all final goods and services

produced within a country in a given period of time.
• It includes only the value of final goods
• GDP includes both tangible goods (food, clothing, cars) and
intangible services (haircuts, housecleaning, doctor visits).
• GDP includes goods and services currently produced. It does
not include transactions involving items produced in the past.
• GDP measures the value of production within the geographic
confines of a country.
• GDP measures the value of production that takes place within
a specific interval of time. Usually, that interval is a year or a
quarter (three months).
 Components of GDP

• GDP is divided into four components: Consumption (C),

investment (I), Government purchases (G), and net exports (NX)
• Y = C + I + G + NX
• Each rupee of expenditure included in GDP is placed into one
of the four components of GDP, the total of the four
components must be equal.
• Consumption: - is spending by households on goods and
services.
• Investment:- Investment is the purchase of goods that will be
used in the future to produce more goods and services. It is
the sum of purchases of capital equipment, inventories and
structures.
• Government purchases:- include spending on goods and
services by local, state and federal governments. It includes
the salaries of government workers as well as expenditures
on public works.
• Note: when the government pays salary, it is part of
government purchases. But when a government pays a social
security benefit to a person who is elderly or an
unemployment insurance benefit to a worker who was
recently laid off, these are termed as transfer payments.
• Transfer payments alter household income but do not reflect
the economy’s production.
• From a macroeconomic standpoint, transfer payments are
like negative taxes.
• Net exports: Spending on domestically produced goods by
foreigners (exports) minus spending on foreign goods by
domestic residents (imports).
• The net in net exports refer to the fact that imports are
subtracted from exports.
• Circular flow of income in a two sector economy:
• Money flows from business firms to hhs as factor payments
and then it flows from hhs to firms.
• This flow of money will not always remain at constant level.
• In the year of depression, circular flow of money income will
contract and vice versa.
• If hhs save a part of their income, their savings will affect money
flows in the economy.
• Savings reduce the flow of money expenditure to the business
firms and will cause a fall in economy’s total income.
• Savings are termed as a leakage from the money expenditure flow.
• Savings by hhs need not reduce aggregate spending and income if
they deposit their savings in banks, insurance companies, financial
houses, stock markets.
• Firms borrow from these institutions to invest in capital goods.
• Thus the savings of hhs deposited in financial market are again
brought in to the expenditure stream and as a result total flow of
spending does not decrease.
• Saving is withdrawal (leakage) of some money from the
income flow and investment is injection of money in
circular flow of income.
• Planned savings = Planned investment
• A fall in planned investment – income, output and
employment fall- flow of money contract.
• Increase in savings- demand for goods fall- fixed
investments fall.
• Classical economists believe that financial market
provides a mechanism which coordinates the savings
of hhs and investment expenditure.
• Rate of interest is the price for the use of savings, is determined by
saving and investment.
• If savings > investment, rate of interest falls- investment increases
and both become equal.
• If investment > savings, rate of interest rises- at a higher rate of
interest, savings increase and become equal to planned
investment expenditure.
• Keynes refuted this argument.
• In a two sector economy with no government and foreign trade,
value of output produced (Y) = value of output sold.
• Y=C+I
• Since national income can be either consumed or saved
• Y=C+S
• C+I=Y=C+S
• Left hand side shows the components of aggregated demand (aggregate
expenditure on goods and services produced) and the right hand side
shows the allocation of national income to either consumption or saving.
• That means the value of output produced or sold is equal to the total
income received.
• Now subtracting C from both sides we have
• I = Y= S or
• I=S
• Investment is identically equal to saving.
• If savings > investment then interest rate (i) falls, and at this lower
interest rate, investment increases.
• Then S equals I
• S=I
 Circular flow of income in a three sector economy

• Government absorbs a good part of the incomes earned

by hhs.
• Govt. purchases goods and services just as hhs and firms.
• Govt. expenditure takes many forms including spending
on capital goods and infrastructure (highways, power,
communication), defense goods, education , public
health and so on.
• Money flow from hhs and firms to govt is termed as tax
payments.
• Another method of financing govt. expenditure is
borrowing from the financial markets(Govt. borrowing).
• Govt. borrowing – increases the demand for credit- raises interest rate. This affects
the behaviour of hhs and firms.
• Business firms consider the interest rate as cost of borrowing and the rise in the
interest rate as a result of borrowing by govt. lowers private investment.
• On contrary, hhs view the rate of interest as return on savings feel encouraged to
save more.
• Total expenditure (E) = C + I + G
• Total income (Y) = C +S +T
• C+I+G=C+S+T
• I+G=S+T
• G-T = S-I
• If govt. expenditure is greater than tax revenue, the govt will have a deficit budget.
• To finance deficit budget, govt will borrow from financial market.
• Then private investment by business firms must be less than the savings of the hhs.
• Thus govt. borrowing reduces private investment in the economy. In other words,
government borrowing crowds out private investment.
 Circular income flow in a four sector economy

• Money flows occur in the open economy when exports and imports
also exist in the economy.
• In the open economy interaction between countries takes place not
only through exports and imports of goods and services but also
through borrowing and lending funds or financial market.
• Trade surplus- net capital inflows – foreigners will borrow from
domestic savers to finance their purchases of domestic exports.
Domestic savers will lend to foreigners, that is, acquire foreign assets.
• Trade deficit- net capital outflows – domestic consumer hhs and
business firms borrow from abroad to finance their excess of imports.
As a result, foreigners will acquire domestic financial assets.
• NY= C+I+G+NX
• C+I+G+NX = C+S+T
 Concepts of National Income

• GDP- Net Factor income from abroad = GNP at market

prices.
• Net factor income = the difference between factor income
received from abroad by normal residents of India for
rendering factor services in other countries on the one
hand and the factor incomes paid to the foreign residents
for factor services rendered by them in the domestic
territory of India on the other.
• NNP = GNP-Depreciation
• National income at factor cost = Net national product or
National Income at market prices – indirect taxes +
subsidies.