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Subject BUSINESS ECONOMICS

Paper No and Title 5. Macroeconomic Analysis and Policy

Module No and Title 1. Introduction

Module Tag BSE_P5_M1

BUSINESS PAPER No.5 : MACROECONOMIC ANALYSIS AND POLICY

ECONOMICS MODULE No.1 : INTRODUCTION
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TABLE OF CONTENTS

1. Learning Outcomes
2. Introduction
3. Major Schools of Thought: A Brief Overview
4. Importance of Macroeconomics
5. Central Macroeconomic Issues
5.1 Level of Output
5.2 Unemployment
5.3 Economic Growth
5.4 Business Cycles
5.5 Inflation
5.6 Public Debt
5.7 Globalization and its Implications
6. Key Macroeconomic Indicators for India
6.1 India’s Growth Performance
6.2 Exchange Rate Systems and Trends in India
7. Course Outline
8. Summary

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1. Learning Outcomes
After studying this module, you shall be able to

 Identify key macroeconomic issues

 Have an initial understanding regarding the viewpoints of Classical vis-a-vis Keynesian
economists
 Differentiate between microeconomics and macroeconomics
 Understand the importance of studying macroeconomics
 Learn about several relevant macroeconomic issues (e.g., level of aggregate output,
unemployment, inflation budget deficit etc.)
 Analyze key macroeconomic indicators for India such as economic growth and external
account balance

2. Introduction
Issues such as unemployment, inflation, GDP growth rate and exchange rate are commonly used
in the day to day conversation of policy makers, media persons and even the common man. These
are related to macro aspects of the economy. The branch of economics that deals with the study of
these aspects is known as Macroeconomics. Unlike the micro aspects that deal with analysis of
the behavior of a single entity such as a firm, a consumer, a worker or an investor,
macroeconomic variables capture the aggregate behavior of all agents (households, firms and
government) in an economy. For instance, the aggregate consumption function is based on total
planned consumption expenditure of all the agents and its relation with aggregate income in an
economy. Similarly, the investment function is based on total planned investment of all the firms
in an economy.

Thus, microeconomic analyses focus on the performance of a single unit in an economy. While,
the macroeconomic analyses tries to capture the performance of all units in an economy and study
their implications. As may be obvious to you, while we the study the behavior of a single unit, a
large number of other things are kept constant. For instance, in microeconomics while studying
the law of demand, you may have read the assumption of ceteris paribus, which means all other
factors apart from price of the commodity are assumed constant. However, in macroeconomics
the behavior of a lot of interlinked variables have to be considered simultaneously to understand
how aggregate variables are determined in an economy.

3. Major Schools of Thought: A Brief Overview

A large number of complex economic ideas, beginning with the Classical school of thought have
emerged over time. The Classicals believed in a free market economy with least government
interference. They believed that if left on its own, markets would adjust automatically and reach
the full employment equilibrium driven by wage and price flexibility. The full employment level
is attained when all resources in the economy are fully utilized.

The Great Depression of 1930s questioned the validity of the classical beliefs of laissez faire
(minimal government interference) and full employment. During the same period, John Maynard
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Keynes published his classic, The General Theory of Employment, Interest and Money. Unlike
the Classical economists, Keynes believed that active government intervention was necessary to
enhance the low level of aggregate demand in the economy and pull it out of depression.

The limitations of Keynesian theory were attacked by Monetarists, also known as New Classical
economists. Despite its limitations, Keynesian economics remains an essential pillar supporting
the foundations of modern macroeconomics.

As we shall see in this course, the study of macroeconomics will provide an understanding of the
major economic issues facing countries today and provide insights into key variables that shape
aggregate economic outcomes.

4. Importance of Macroeconomics
The present module attempts to take you through a macroeconomic exploration of the main issues
faced by countries across the world. These issues have become extremely relevant in
understanding the fiscal and monetary policy stance of governments. Macroeconomic models are
routinely used by policy makers for addressing problems related to growing unemployment,
rising inflation and falling rates of economic growth.

Further, continuous changes are taking place in the global macroeconomic arena. Analysis of
these developments offer insights into how such situations may be dealt with in the future. For
instance, macroeconomic analysis helps to understand the reasons underlying the recent global
financial crisis in terms of its key drivers and the appropriate policy response. Such analyses help
in seeking answers to questions such as, why do financial crises occur frequently and grip
countries across the world at an alarming rate.

5. Central Macroeconomic Issues

A number of macroeconomic variables will be discussed in this course. Some of them are
national income and related aggregates such as Gross National Product (GNP), Gross Domestic
Product (GDP); national savings and investment; indicators to assess price changes such as price
deflators, inflation and deflation index; employment and output; policies such as fiscal and
monetary policy; external indicators such as exchange rate (appreciation and depreciation) and
Balance of Payments (deficit or surplus). It is important for an economist to understand these
concepts and definitions, factors affecting these variables and inter-linkages among them. This is
crucial for suggesting suitable policy prescriptions, whenever these deviate from optimal levels.
These variables will be defined and concepts developed in detail through the various modules in
this course.

Every government needs to emphasize and strive for higher levels of output, lower levels of
unemployment and low and stable rates of inflation. At this stage, let us discuss the importance of
these issues.

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5.1 Level of Output

The level and growth rate of output may be assessed by measuring different national income
aggregates such as Gross Domestic Product (GDP) and National Income. In the module on
national income we will learn that GDP is a measure of all final goods and services that are
produced in a given year within the domestic economy. A number of other useful national income
aggregates will also be introduced.

The overall level of output in an economy determines the standard of living of an economy. The
income and hence the consumption and saving decisions of a household depend on it. In other
words, higher levels of output directly translate into better availability of goods and services.
Thus, if U.S. has higher level of output relative to India then that would imply that the U.S.
citizens must be enjoying better living standards, on average.

If two countries have similar output levels, then the country that has higher per capita output is
likely to enjoy better living standards. The per capita output levels may be computed as total
output level divided by population of the country. A higher level of output would also imply
higher employment in an economy. Unemployment is one of the crucial variables that are of
interest to policy makers. This is explained in the next subsection.

5.2 Unemployment

Policies to check the unemployment rate are popular and on the agenda of all political parties in
developing countries such as India. It is defined as the number of people in the working age group
who are unemployed (i.e. those who are looking for jobs but are unable to find them), as a
proportion of total labor force. The level of output in an economy is one of the central
macroeconomic variables as it determines the level of economic activity and hence the pace of
job creation.

5.3 Economic Growth

The sustained rise in standard of living implies higher growth. All economies strive to attain
higher economic growth. A substantial volume of literature deals with growth economics. The
objective of these studies is to develop optimal growth models for an economy. Since all
economies are characterized by different resource endowments, the optimal path of development
for each economy is likely to be different. The path is also likely to vary with the time period in
which the economy is about to take-off. We will elaborate on these growth models in detail in the
relevant modules in this course. These models help us identify the key factors that drive growth in
the long run.

5.4 Business Cycles

The macroeconomic objectives of a country include not just attaining higher level of output. It is
actually more important for a country to maintain a stable level of production. However, all
economies experience fluctuations in economic activity. The business cycles are spells of booms
characterized by rising output and falling unemployment that are sometimes followed by periods
of recession when production falls while unemployment soars. Macroeconomists attempt to
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measure these aggregates and suggest policy prescriptions so as to minimize these fluctuations.
These fluctuations bring in an element of uncertainty that is seen to adversely affect the economy.
Accordingly, the measurement and understanding of these national aggregates become useful. In
our macroeconomics course as we learn about Classicals and Keynesians, we will see that the
policy prescriptions made by economists belonging to these schools of thought can often be quite
different. The classical economists would like to let the market correct on its own. The
Keynesians, on the other hand, would want the government to actively intervene in the market to
bring the economy out of depression.

5.5 Inflation

As we discussed above, fluctuations result in uncertainty. Any uncertainty in the economy adds to
instability in the investor’s sentiments that might negatively affect investment and hence future
rate of growth of economy. Similar to the fluctuations in output, fluctuations in prices is
considered harmful for the economy. Persistently rising prices, referred to as inflation, adversely
affects the living standards of people as it reduces the purchasing power of money. The poor are
seen to be most adversely affected during inflation. Inflation, thus, results in rising socio-
economic disparities in the society. Due to this, analysis of the determinants of inflation occupies
an important place in macro analysis.

5.6 Public Debt

Every government of has to incur huge expenditure in order to provide a number of goods and
services. In the absence of sufficient revenue sources, the governments have to operate with
budget deficits. To finance these deficits, a government often has to incur debt, which may be
internal (borrowings from domestic agents) or external (borrowings from foreigners).
International financial institutions such as the International Monetary Fund (IMF) lay emphasis
on maintaining fiscal discipline and reducing profligacy. International credit rating agencies (like
Standard & Poor, Moody’s etc.) downgrade the international credit rating of a country that has
persistent deficits and a huge debt burden (especially foreign debt). In this course we will explore
the implications of governments’ fiscal deficit situations and debt burden, especially in context of
the Indian economy.

5.7 Globalization and its implications

The interdependence across countries is increasing as a result of rising globalization. All modern
day economies would like to draw maximum benefits from free exchange of goods, services,
capital, ideas and technologies from the rest of the world. Deregulation and lower restrictions on
international transactions have facilitated international trade and many argue that this has resulted
in greater benefits to all participating countries. The rapid developments in transport, information
and communication have further facilitated the opening-up of these economies. Of course, there
are also many negative aspects of too much integration with the world economy; some of these
are discussed in the module of the recent global financial crisis. Too much opening up exposes
the economy to risk and volatility. It also reduces the effectiveness and control over the outcome
of domestic policies to a large extent. The study of global macroeconomic issues would equip us
to understand some of these international aspects.

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6. Key Macroeconomic Indicators for India

India has been able to attain sustained high growth rates of GDP, in the range of 7 to 8 per cent
for quite some time now, growing faster than most global economies today. In addition, the
economy has been more or less successful in keeping itself insulated from uncertainties and
turbulence in financial markets. Although, it is expected that it might not be too easy to maintain
such rates of growth in future and that doing so would require appropriate oversight and
regulation.

India today has emerged as an economy that has promising future prospects. The Economic
Survey, 2014-15 states that from the macroeconomic perspective, the economy has done fairly
well in terms of several indicators such as inflation, fiscal deficit, external account balances,
foreign exchange reserves, domestic demand and exchange rate of rupee. The present section
attempts to trace a few key trends in the evolution of the Indian economy, especially in terms of
some of the macroeconomic indicators discussed above.

6.1 India’s Growth Performance

The Central Statistical Organization (CSO) is responsible for estimating the national income in
India. It has recently revised the national account aggregates by shifting the base year from 2004-
05 to 2011-12. You will understand the concepts of ‘base year’, ‘real’ and ‘nominal GDP’ etc. in
the very next module. The present section outlines the growth record of Indian economy since
independence.

The Indian economy at the eve of independence was characterized by extreme poverty, illiteracy,
superstition, very low levels of income per capita, high incidence of diseases and high mortality
and birth rates. It lacked basic infrastructure like roads, while health and education of the people
suffered. Agriculture was largely neglected and subject to wide fluctuations as it was dependent
on monsoons. Hence, the economy displayed very poor growth performance in this period.
Thereafter with the adoption of planned economic development, even though substantial progress
was made on many fronts, the growth rate of real Gross Domestic Product (GDP remained
modest till the 1970s. Figure 1 provides the trends in GDP in India from 1951-52 to 2014-15.

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GDP
12

10

-2

-4

-6
Figure 1: Trends in Gross Domestic Product (GDP), 1951-52 to 2014-15
Source: Central Statistical Organization (CSO)

In the 1980s, as the economy began to undertake “piecemeal” or “silent” reforms, the growth
rates picked up somewhat. But, till 1991 the growth rates were extremely low. In fact the growth
rates of around 2 percent was often termed the “Hindu rate of growth”. Investments were also
quite low with a rate of gross capital formation of around 20 per cent.

As a comprehensive set of reforms in the external, financial, fiscal, monetary, private and public
sector were undertaken in 1991 to boost efficiency and competitiveness, economic growth gained
momentum. Although the rates of growth remained high compared to India’s previous
performance yet they were modest by international standards, when compared with Asian
countries such as China.

In the latter half of the 1990s, there was loss in growth momentum, owing to a number of factors,
both internal and external, viz., the East Asian crisis (financial crisis that emerged in Thailand and
later engulfed many East Asian countries), lack of effective fiscal management, poor agricultural
performance as a result of bad monsoons, monetary tightening that lowered investments in the
private sector, decline in public investments and slowing down of the pace of reforms.

After 2003, a rise in growth rates was experienced due to a number of reasons such as
restructuring in industrial sector, reduction in domestic interest rates resulting in higher
investments, better corporate performance resulting in increased profitability, favorable external
conditions (in terms of unprecedented high growth in world economy and exports)etc. As a result,
GDP grew rapidly during this period only to slow down once again after the onset of the global
financial crisis (to be discussed in one of the later modules in this course).

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6.2 Exchange Rate Systems and Trends in India

Today almost all economies are open to trade and financial flows in varying degrees. Although
restrictions on international trade and financial flows still exist in the form of taxes, tariffs and
controls on labor and capital movement, these have been reduced significantly in recent years.
Therefore, it is important to understand the concept and trends in exchange rates that have critical
implications for India’s transactions (involving trade and capital flows) with the rest of the world.

The exchange rate between currencies may be defined as the number of units of domestic
currency (viz., rupee) required to purchase a unit of foreign currency (let’s say, dollar). It is the
key financial variable that affects policy decisions of international traders, financial institutions,
investors etc. who keenly follow movements in this variable. India has adopted different
exchange rate policies overtime. Dua and Ranjan (2010) in their study on exchange rate policy
and modeling in India review the exchange rate policy in India and develop a model for the rupee
dollar exchange rate. The following table summarizes it succinctly.

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Table 1 : Chronology of the Indian Exchange Rate

Year The Foreign Exchange Market and Exchange Rate
1947-1971 Par Value system of exchange rate. Rupee’s external par value was fixed
in terms of gold with the pound sterling as the intervention currency.
1971 Breakdown of the Bretton-Woods system and flotation of major currencies.
Rupee was linked to the pound sterling in December 1971.
1975 To ensure stability of the Rupee, and avoid the weaknesses associated
with a single currency peg, the Rupee was pegged to a basket of
currencies. Currency selection and weight assignment was left to the
discretion of the RBI and not publicly announced.
1978 RBI allowed the domestic banks to undertake intra-day trading in foreign
exchange.
1978-1992 Banks began to start quoting two-way prices against the Rupee as well as
in other currencies. As trading volumes increased, the ‘Guidelines for
Internal Control over Foreign Exchange Business’ were framed in 1981.
The foreign exchange market was still highly regulated with several
restrictions on external transactions, entry barriers and transactions costs.
Foreign exchange transactions were controlled through the Foreign
Exchange Regulations Act (FERA). These restrictions resulted in an
extremely efficient unofficial parallel (hawala) market for foreign exchange.
1990-1991 Balance of Payments crisis
July 1991 To stabilize the foreign exchange market, a two-step downward exchange
rate adjustment was done (9% and 11%). This was a decisive end to the
pegged exchange rate regime.
March 1992 To ease the transition to a market determined exchange rate system, the
Liberalized Exchange Rate Management System (LERMS) was put in
place, which used a dual exchange rate system. This was mostly a
transitional system.
March 1993 The dual rates converged, and the market determined exchange rate
regime was introduced. All foreign exchange receipts could now be
converted at market determined exchange rates.
Source : Dua, P and Ranjan R (2010), Exchange Rate Policy and Modelling in India, Study
No. 33, Development Research Group (DRG), Reserve Bank of India

The foreign exchange market has transformed into an efficient and liquid market as against a
deeply regulated one prior to 1990s. The Indian rupee has mostly depreciated against the dollar
after 1993, except during the period 2003-05 and 2007-08. In both these periods rupee has
appreciated due to large inflows of capital and also because of weakening of dollar in the global
markets. In addition, the rupee has also depreciated against other currencies. However, rupee has
emerged as a more stable currency over time and its volatility has reduced. This is despite the
volatility observed in international oil prices and in capital (especially short term) and trade

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flows. The Reserve Bank of India (RBI) has been able to maintain organized working in the
foreign exchange market despite various disturbances in internal and external markets.
The present module attempts to make the reader aware of some of the crucial macroeconomic
issues and aspects in the Indian economy. We would have more to say about these in various
modules of this course.

7. Course Outline
The modules in this course are organized so as to introduce you to a few basic accounting
concepts and tools at the very outset. These include the concepts of GDP, GNP and related
variables and concepts of Balance of Payments, exchange rates, capital flows etc., that are
essential for analyzing countries’ linkages with the rest of the world. Thereafter we gradually
introduce a number of models that are useful for macroeconomic analysis. We begin with fairly
simple models based on a number of simplifying assumptions; the assumptions are relaxed
gradually, leading to more complex models that are closer approximations of reality.

First we introduce the basic Keynesian macro model that captures the inter-linkages between real
and financial sectors in open and closed economies. This is followed by a more general model
with flexible prices (the Aggregate Demand-Aggregate Supply model) that incorporates the
effects of the labor market as well. The relation between interest rates and exchange rates, the
theory of inflation, theories underlying consumption and investment demand functions and
business cycles are also dealt with in detail, before introducing growth models for analyzing the
determinants of economic growth in the long run. Finally, certain critical policy issues related to
the external sector (e.g., financing of current account deficits and implications of capital flows),
India’s fiscal and monetary policies and the recent financial crisis are also explored in detail using
the concepts, tools and macro models developed in the initial part of the course.

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8. Summary
 The branch of economics that deals with aggregate behavior of all agents in an economy
is known as Macroeconomics.
 Classical economists believed in free market economy with laissez faire (minimal
government interference).
 Unlike the classical economic framework, Keynes believed that active government
intervention is called for to enhance aggregate demand and pull an economy out of
depression.
 The study of macroeconomic issues is essential to understand the continuous
developments taking place in global macroeconomic arena.
 The major macroeconomic issues relate to determination of aggregate output (GDP,
GNP etc.) and employment, national savings and investments, fiscal and monetary
policies and external indicators (e.g., exchange rate and Balance of Payments situation).
 India has emerged as an economy with promising future economic prospects.
 The Central Statistical Organization (CSO) is responsible for measuring the national
income in the country.
 Indian economy experienced stagnation in real Gross Domestic Product (GDP) till the
1970s.
 The growth rate gained momentum after the comprehensive set of reforms undertaken in
1991, believed to have increased efficiency and competitiveness in economy.
 India’s exchange rate policy has evolved overtime as its economy has gradually opened
up.
 Since independence, India’s exchange rate policy has seen a shift from a par value system
to a basket peg and then to a managed floats exchange rate system.

BUSINESS PAPER No.5 : MACROECONOMIC ANALYSIS AND POLICY

ECONOMICS MODULE No.1 : INTRODUCTION