1

MacroeconomicsEPBM 16

Sudip Chaudhuri

1st Part(Topics 1 to 3)

2

Topics

1. Overview of Macroeconomics

2. National Income Accounting

3. Business Cycles and Multiplier

4. Money and Monetary Policy

5. Balance of Payments and Foreign Exchange Rates

6. Open Economy Macroeconomics

7. Strategy of Economic Development

3

Topic 1

Overview of Macroeconomics

4

What is Macroeconomics?

• Microeconomics focuses on how decisions are made by individuals and firms and the consequences of those decisions

• Macroeconomics examines the aggregate behavior of the economy – how the actions of all individuals and firms in the economy interact to produce a particular level of economic performance as a whole.

5

Great Depression

• The sharp fall in aggregate output and employment levels which started in 1929 and lasted through the 1930s

• This gave rise to modern macroeconomics– Macroeconomic theory changed dramatically

with the 1936 publication of the book, The General Theory of Employment, Interest and Money by John Maynard Keynes

– Important mission of modern macroeconomics: to prevent anything like the Great Depression from happening again

6

The Great Depression

7

Potential output

K : Total physical capital stock, i.e., total final investment goods installed in the economy at a point of

time

Potential output: Maximum possible production level (at constant prices) during the period

(year), given K, supply of labour, human capital, technology etc

K

Potential Output

8

Goods and services produced

• Intermediate goods and services, i.e, those which are used up in the process of production, e.g., yarn for weaving cloth, iron-ore for producing steel, fertilizers for producing wheat

• Final consumption goods and services, i.e., those which are purchased by the household sector. Examples are: rice, garments, fees paid to doctors, bus fare refrigerator, TV

• Final investment goods, i.e., durable goods like plant and machinery, buildings, roads, bridge

9

Demand-constrained economy(aggregate demand < potential output)

(Recession/depression)

Potential amount not producedAggregate demand

Potential outputK

10

Recession/depression

• Recession:– Decline in output, income and employment

lasting more than few months • Depression:

– a recession that is large in both scale and duration

11

Supply-constrained economy (aggregate demand > potential output)

(Demand-pull inflation)

Potential output

Aggregate demand

K

12

Inflation

• Demand-pull inflation• Cost-push inflation• Stagflation

13

Market

• Is a mechanism through which buyers and sellers interact to determine prices and exchange goods and services

• Different types of market:– Details in the next Economics course

14

Competitive Market

• Is a market in which there are many buyers and sellers of the same good or service

• Three elements:– Demand curve– Supply curve– Equilibrium price

15

Market Equilibrium

16

Shifts in Supply or Demand Change

Equilibrium Price and Quantity

17

MacroeconomicsThree central questions

• Why do output and employment sometimes fall and what can be done about it

• What are the sources of inflation and how can it be controlled

• How can a nation increase its rate of economic growth

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Why demand is deficient and how it can be increased

Aggregate demand

Potential outputK

19

How demand can be managed to tackle

demand-pull inflation

Potential output

Aggregate demand

K

20

How K (and productivity etc) can be increased

to accelerate growth

Potential outputK

21

Measuring economic success

• Growth of output - GDP and per capita GDP/GNI

• Price stability - Inflation rate• Low unemployment (and poverty) rates• External balance:

– Trade deficit– Current account deficit (CAD)– BOP deficit

22

Growth rate

• Growth rate of GDP (percent)

((GDPt – GDPt-1)/GDPt-1) x 100

• Inflation rate

((Pt – Pt-1)/Pt-1) x 100, where

–P: Annual averages of price indexes

–Or Year-on-year

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1951

-52

1955

-56

1959

-60

1963

-64

1967

-68

1971

-72

1975

-76

1979

-80

1983

-84

1987

-88

1991

-92

1995

-96

1999

-00

2003

-04

2007

-08

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Growth Rate of Real GDP, India, 1951-2008

Year

An

nu

al g

row

th r

ate

in p

erce

nt

24

1950

-51

1954

-55

1958

-59

1962

-63

1966

-67

1970

-71

1974

-75

1978

-79

1982

-83

1986

-87

1990

-91

1994

-95

1998

-99

2002

-03

2006

-07

0

5000

10000

15000

20000

25000

30000

Per Capita Real GNP, India, 1951-2008

Year

In R

up

ees

25

26

USA

SOUTH KOREA

RUSSIA

MALAYSIA

BRAZIL

CHINA

INDIA

0 10,000 20,000 30,000 40,000 50,000

47,094

29,518

15,258

13,927

10,607

7,258

3,337

Gross National Incomeper capita, 2008, $ PPP

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Purchasing Power parity

• The PPP between two countries’ currencies is the exchange rate at

which a given basket of goods and services would cost the same amount

in each country

• Suppose a basket of goods and services that costs $ 100 in USA, costs

Rs 900 in India. Then the PPP is Rs 9 per US $

• Re-$ PPP is approx 20% of the market exchange rate

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Real GDP per capita

29

1971

-72

1974

-75

1977

-78

1980

-81

1983

-84

1986

-87

1989

-90

1992

-93

1995

-96

1998

-99

2001

-02

2004

-05

2007

-08

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

30.0

Price Inflation, WPI, India, 1970-2009

Year

Rat

e o

f in

flat

ion

in

per

cen

t

In India, Wholesale Price Index more common than Consumer Price Index

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1990

-91

1992

-93

1994

-95

1996

-97

1998

-99

2000

-01

2002

-03

2004

-05

2006

-07

2008

-09

-12.0

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

India's Trade and Current Account Deficit

Trade deficitCAD

Year

As

per

cen

tag

e o

f G

DP

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Rural Urban Combined

Percentage

1973 56.4 49.0 54.9

1983 45.7 40.8 44.5

1993 37.3 32.3 36.0

2004 28.3 25.7 27.5

Number (Lakhs)

1973 2612.9 600.46 3213.36

1983 2519.57 709.4 3228.97

1993 2440.31 763.37 3203.68

2004 2209.24 807.96 3017.20

Persons below Poverty line in India

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Tools of Economic Policy

• Fiscal Policy:– Government expenditure and taxes

• Monetary Policy:– Money supply, credit, interest rates

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Recommended text

• Paul Samuelson and William Nordhaus

Economics, 19th edition

Tata McGraw Hill

Indian Adaptation by

Sudip Chaudhuri and Anindya Sen,

Chapters 19 to 31

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For Examination

• PPTs uploaded• Class discussions• Economics, 19th edition:

– Chapter 19 (except pages 476 to 481)– Chapter 20– Chapter 21– Chapter 22 (except pages 557 to 559)– Chapter 23 (except pages 593 to 595; 602 to 605)– Chapter 24 (except pages 625 to 638)– Chapter 27 (except pages 720 to 724)– Chapter 28 (except pages 745 to 757)

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Some useful sources of data

• UNDP: http://hdr.undp.org/en/statistics/data/• IMF: http://

www.imf.org/external/pubs/ft/weo/2008/01/weodata/index.aspx

• World Bank: http://worldbank.org• RBI: http://

www.rbi.org.in/scripts/AnnualPublications.aspx?head=Handbook%20of%20Statistics%20on%20Indian%20Economy

• Min of Finance: http://indiabudget.nic.in/• CSO: http://mospi.gov.in/mospi_cso_rept_pubn.htm

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Topic 2

National Income Accounting

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The National Accounts

Almost all countries calculate a set of numbers known as the national income and

product accounts.

The national income and product accounts, or national accounts, keep track of the flows

of money between different parts of the economy.

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In India

Central Statistical Organization, New Delhi publishes every year the National Accounts

Statistics(http://mospi.gov.in/mospi_cso_rept_pubn.htm)

(New users can register free)

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Gross Domestic Product

• Market value of all FINAL goods and services produced within a country in a given period of time

• Note:– Included in GDP:

• Not only goods but also services• Only those with market value • Even if not sold

– Excluded in GDP:• Financial assets like stocks • Foreign produced goods & services• Used goods

• FINAL: does not mean intermediate goods & services are ignored

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Two ways of calculating GDP

• Final use (or Flow of product) method– Here we ignore the intermediate goods and services

and concentrate only on the Final goods and services which have not been used up in the process of production

– GDP is calculated by adding the value of production of all the final goods and services produced, i.e., the value of production of all the final consumption and investment goods and services.

• Income (or earnings) method– GDP is calculated by adding all the factor incomes

accruing to the household sector.

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Some definitions• Value of production is defined as (quantity of

production) x (price of the product). Thus the value of cloth produced = (quantity of cloth produced in meters) x (the price per meter)

• Profits = Sales – wages – raw materials/services costs

• Thus Sales = profits + wages + raw materials/services costs

• Value added is defined as Value of production - cost of raw materials purchased= Profits + wages

(Note: other incomes are interest and rent)

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Yarn cost

W1

R1

Cloth

Yarn

R: profits

W: wages

R2

W2

Cotton cost R3

W3

Cotton

43

Problem of “double counting”

• Problem arises if we take value of production of all goods and services, i.e., both intermediate and final

• Problem tackled by taking:– VALUE OF PRODUCTION of ONLY FINAL

goods and services– or VALUE ADDED of ALL goods and services

44

Thus

• GDP

= C + I + G + X (Product approach)

= Profits + wages + other incomes

+ depreciation + net production taxes (Earnings approach)

• Aggregate production generates equivalent incomes

• Note: GDP at market price = GDP at factor cost + indirect taxes – subsidies.

45

WhereC: Consumption = aggregate consumption

expenditure by households on goods and services

I: Private Investment = aggregate investment expenditure by private sector= Fixed investment = expenditure on final

investment goods (durable goods like plant, machinery, buildings)

+ Net change in inventoriesG: Aggregate government expenditure on goods

and services including on investment goodsX: Net exports = Aggregate exports of goods and

services minus Aggregate imports of goods and services

NOTE: If I = total I, then G = consumption expenditure

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Why Imports are deducted

GDP = (C – Cm) +(I – Im) +(G – Gm) +(Ex – Exm), where Ex: exports

Or, GDP =C + I + G + Ex – (Cm + Im + Gm + Exm)

Or, GDP = C + I + G + Ex – M, whereM = Cm + Im + Gm + ExmOr, GDP = C + I + G + X

47

Circular Flow Diagram

The Flows of money, goods and services and factors of production

48

49

Circular Flow Diagram

• Connects the four sectors of the economy– Households– Firms– Government– and the Rest of the world

• Via three types of markets– the factor markets– the markets for goods and services– and the financial markets

50

Income

Land,

Labour,

capital

Goods &

services

bought

Consumer spending

Goods &

Services sold

Factors of

production

Wages, rent, interest,

dividends

Revenue

Two-Sector Circular Flow Diagram

FIRMS

HOUSEHOLDS

Factor marketsMarket for goods

& services

51

Consumer

spending

Govt exp on

goods & services

Firms

Households

Factor

marketsMarket for goods

& services

Financial

markets

Government

Rest of

World

Wages etc

Wages etc

Barrowing & stocks issued

Imports

Exports

I spending

GDP

Household savings

Government borrowing

Foreign borrowing etc

Foreign lending etc

TaxesTransfersSalaries

52

Demand-constrained economy

Aggregate demand = C+I+G+X

Potential outputK

53

GNP (or GNI)

• Gross national product or Gross national income is defined as the sum total of the incomes which accrue to the residents of the country

• Residents – individuals and enterprises:– Not based on nationality or legal criteria but

on– “Center of Interest” in the economy

54

GNP (or GNI)

GNP =

GDP + (earnings of residents from supply of factors of production to non-residents) – (payments made by residents to non-residents for factors of production received)

Or, GNP = GDP + net factor earnings of the residents from the rest of the world

55

Real GDP

GDP at constant prices to find out how aggregate production has

changed in real terms

56

Example

Year 1 Year 2

Quantity of apples 2000 2200

Price of apple Rs 10 Rs 15

Quantity of oranges 1000 1200

Price of orange Rs 5 Rs 7.5

Nominal GDP Rs 25000 Rs 42000

Real GDP Rs 25000 Rs 28000

57

Real GDP

• Real GDP (GDP at constant prices)– it is the total value of final goods and services

produced in the economy during a year, calculated as if prices had stayed constant at the level of some given base year (1999-2000; recently changed to 2004-05)

• Nominal GDP (GDP at current prices),– GDP number that has not been adjusted for changes

in prices is calculated using the prices in the year in which the output is produced

58

1952

-53

1956

-57

1960

-61

1964

-65

1968

-69

1972

-73

1976

-77

1980

-81

1984

-85

1988

-89

1992

-93

1996

-97

2000

-01

2004

-05

0

1000000

2000000

3000000

4000000

5000000

Nominal and Real GDP, India, 1951-2008

GDP at Factor Cost at current pricesGDP at factor cost at 1999-2000 prices

Year

Rs

cro

res

59

Inflation

• Process of overall price rise• Calculated on the basis of price indexes:

– WPI more common than CPI in India

• Implicit GDP deflator (ratio of Nominal GDP/Real GDP)

60

Price Indexes used in India Base year

Compiled by

Wholesale Price Index (WPI) 1993-94(recently changed to 2004-05)

Office of the Economic Adviser, Ministry of Commerce and industry

Consumer Price Index for Industrial Workers (CPI-IW)

2001 Labour Bureau, Ministry of Labour and Employment

Consumer Price Index for Agricultural Labour (CPI-AL

1986-87 Labour Bureau, Ministry of Labour and Employment

Consumer Price Index for Rural Labour (CPI-RL)

1986-87 Labour Bureau, Ministry of Labour and Employment

Consumer Price Index for Urban, Rural and Combined

2010 Central Statistical Organization

61

WPI

• Base year 2004-05 (2004-05 = 100)• 676 products (consumer, intermediate and capital) with

value weights assigned:– Rice, wheat, vegetables, petrol, biscuits, textiles, medicines,

cement, TV sets, motor vehicles etc• Services not included• Wholesale prices (not retail prices) from selected

markets• Indices calculated for products/sub-groups/groups/all

commodities by calculating the weighted average of price ratios between the current period and the base year

• Monthly/weekly data published in www.eaindustry.nic.in

62

No of products

Weights May, 2011

All commodities 676 100.00 151.7

Primary articles 102 20.12 192.1

Fuel, power 19 14.91 160.4

Manufactured products

555 64.97 137.2

WPI

63

Inflation rate

• ((Pt - Pt-1)/Pt-1)*100

• Annual averages:Pt = 52 week/12 month average of the index in a particular year

Pt-1 = 52 week/12 month average of the index of the previous year.

• Year-on-year (point-to point) basis:Pt = Index in a particular week/month

Pt-1 = Index 52 weeks/12 months earlier

64

1971

-72

1974

-75

1977

-78

1980

-81

1983

-84

1986

-87

1989

-90

1992

-93

1995

-96

1999

-00

2002

-03

2005

-06

2008

-09

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

30.0

Annual Average Inflation rate: CPI and WPI

CPI-IW WPI

65

Jan-

07

Apr-0

7

Jul-0

7

Oct-

07

Jan-

08

Apr-0

8

Jul-0

8

Oct-

08

Jan-

09

Apr-0

9

Jul-0

9

Oct-

09

Jan-

10-2.00.02.04.06.08.0

10.012.014.016.018.0

Year-on-year Inflation rate: CPI and WPI

CPI-IWWPI

Year

Per

cen

t

66

67

Nominal/Real Interest rate

Real interest rate =

Nominal interest rate – Inflation rate

68

Topic 3

Business Cycles and Multiplier

69

Questions

• What causes aggregate income to rise? To fall?

• What causes too little spending – recession and depression?

• What causes too much spending – demand pull inflation?

70

Assume: Demand-constrained economy

Aggregate demand

Potential outputK

71

In reality

• Given a particular K, an economy necessarily does not produce the maximum possible output

• How much is produced depends on the size of the market

• Most of the recessions in the post World War II can in fact be explained by reductions in aggregate demand

72

What are the factors which influence aggregate demand?

73

Consumer

spending

Govt exp on

goods & services

Firms

Households

Factor

marketsMarket for goods

& services

Financial

markets

Government

Rest of

World

Wages etc

Imports

Exports

I spending

GDP

Taxes

74

Initial assumption

• Closed economy• No government• Two sectors:

– Households– Firms

• Hence two types of aggregate demand:– Consumption and– Investment

75

Households, typically

• Use a part of their income for consumption• And save the other part

76

Firms

• Investment expenditure:– Planned investment (mainly fixed investment

expenditure, i.e., expenditure on final investment goods such as plant, machinery)

– Unplanned inventory adjustment• Use retained earnings (business savings)

and loans and other sources to fund investment

77

Consumption Expenditure

• Depends on:–Current disposable income (DI)–And other factors such as:

• Expected future income• Wealth

78

Consumption Function

• Relationship between C and DI, other factors remaining constant

• MPC: marginal propensity to consume = ∆C/ ∆DI = change in C when DI changes by a unit

79

Consumption function other factors remaining the same

80

81

Planned Investment Expenditure(= investment spending = investment demand)

• Private Investment undertaken for profits• Private investment demand depends on:

– Revenues generated by the investment project

– Interest rates (and taxes) that influence the costs of investment

– Business expectations about the state of the economy

82

Expectations

• Are subjective• Are often influenced by current and

recent rates of return• But can be highly volatile due to

changes in the business climate:• Political, ideological, psychological

and other influences on future expectations

83

C

D

EF

G

H

84

85

How aggregate demand determines aggregate output and

income

86

Aggregate Demand Curve(=Total Expenditure Curve)

TE (=C+I)

C

Y0

TE

I is constant by assumption

87

Assumptions

• Firms produce more (subject to capacity constraints) if market demand is greater than their current production

• Firms produce less if market demand is less than their current production

• (Prices are not changed till full capacity is reached)

88

How Aggregate Demand determines Y

TE

Y*

Potential output

Y2

Y1

E1

E2

E*

0

At Y1, Total demand (=E

1Y

1) Total production (=0Y

1=0

1Y

1)

At Y2, Total demand (=E

2Y

2) Total production (=0Y

2=0

2Y

2)

At Y*, Total demand = Total production

Y* is the equilibrium Y

45°

01

02

TE

89

Use of 450 lineTE

Y*

Potential output

Y2

Y1

E1 E

2

E*

0

Note: 01

and 02 are in the 450 line

Thus 0Y1 = 0

1Y

1 and 0Y

2 = 0

2Y

2. The 45° line basically helps to compare demand (measured in y-axis) and

supply (measured in x-axis)

At Y1, E

1Y

1 > 0Y

1 and at Y

2, E

2Y

2 < 0Y

2

45°

01

02

90

Equilibrium Income level

• Is the level where the system tends to stay• It is not necessarily the optimal level• In the previous example, the equilibrium

point Y* is sub-optimal - it is less than the potential output

91

Recessions/Expansions

TE

Y

TE

45-degree line

Y1

Y* Y2

Potential output

Downward shift in

demand

Upward shift in

demand

92

Recessions/Expansions

• Exogenous vs Internal cycles• Examples of crises

– New economy bubble in late 1990s– Housing bubble in late 2000

• Crash in real estate:• Investment in housing falls• As business climate worsens, firms reduce I• People affected reduce C

93

Impact of Increase of Spending on Income:

Multiplier Analysis

94

Multiplier

• A Change in investment spending arising from say a change in future expectations starts a chain reaction in which the initial change in aggregate production leads to changes in consumer spending leading to further changes in production levels.

• Thus production ultimately increases more than the initial increase in investment spending

95

ΔExpenditure = ΔI + b ΔI + b2 ΔI +…..(= Δ Demand)ΔProduction (= ΔY ) = ΔI + b ΔI + b2 ΔI +….. = ΔI (1+ b + b2 +…….) = ΔI where b : marginal propensity to consume 0 < b < 1

How multiplier works

1-b

96

ΔExpenditure = 10 + b10 + b2 10 +…..(= Δ Demand)ΔProduction (= ΔY ) = 10 + b10 + b2 10 +….. = 10 (1+ b + b2 +…….) = 10 where b : marginal propensity to consume 0 < b < 1If b= ¾, then, ultimately, ΔY = Rs 10(4) = Rs 40

How multiplier worksΔI = Rs 10

1-b

97

Multiplier

TE1

Y

TE

45-degree line

Y* Y2

TE2

Potential output

98

Fiscal Policy

• Operates through changes in government expenditure and revenue

• Increasing government expenditure was Keynes’ solution to the Great Depression

99

Fiscal Policy

• Can play a very important role in recession/depression when investment demand is not very sensitive to changes in the interest rate and monetary policy may not be very effective

• Recall: Interest alone does not necessarily influence I - also important is the expected rate of return

100

Expansionary Fiscal Policy

• Upward shift of the aggregate demand curve through:– Larger government expenditure on goods and

services (G ↑) - Keynes’ example of digging trenches and filling them up

– Lower taxes on households (C ↑)– Investment tax credit; lower corporate profits taxes (I

↑)• Output goes up not only due to the initial ↑ in

expenditure but subsequent rounds of increases (recall multiplier)

101

Impact of government expenditure

102

Effect of Direct Taxes on Consumption Function

Y

C

C1 (post tax C)

C

As direct taxes ↓ , for same Y,

Disposable Y ↑ and

hence C ↑ and vice versa

103

Note

• If government expenditure is financed by direct taxes, net demand impact will be less

• During recession/depression, even if government expenditure is financed through printing of money, it may not be inflationary