GDP deflator = Nom GDP / Real GDP = P(current)/ P(base yr)

CPI only includes a basket of goods whereas GDP includes price of all the goods

Potential GDP < Actual GDP – positive output gap(Boom or overheated eco)

 Wages ↑leads to Income ↑, Demand ↑, Price ↑ , Inflation ↑ (Power- hands of emp) - this
is growth inflation trade off

Potential GDP > Actual GDP – negative output gap (slowdown, if continues for more than 2 quater
then recession)

 Wages ↓ => Income ↓ => demand ↓ => Price ↓ => inflation ↓ ( power-in the hands of Co)

Natural rate of emp – rate of emp that corresponds to potential GDP

Sacrifice ratio – How much inflation u need to sacrifice if u want to grow o/t by 1%.

W.r.t Direction

 Procyclic var – Which increases when GDP inc – Eg Inflation

 Countercyclic var – Which dec when GDP increases Eg – unemp rate
 Acyclic var – no relation with GDP

w.r.t Time
 Leading indicator – these ↓ or ↑ before any change in GDP – helps in forecast
 Coincident indicator - ↑ or ↓ at the same time as GDP
 Lagging war – Identify when the slowdown is over
Keynesian model of Income determination
Assumptions- 1. Prices are sticky (in SR)
2. Firms are willing to sell any amt of o/t at a given price level
In eqm , Y = AD
Else, when Y > AD => IU (unplanned inventory) = Y-AD > 0 (+) Hence, next yr firms will
produce less => factor income ↓ then GDP↓
Y < AD => IU = Y-AD < 0 (-) Hence, next yr firms produce more
=> factor income ↑ then GDP↑
AD =C + I + G + NX
G, NX = 0
AD =C+I , C = C(bar) + cY where c= marginal propensity to consume i.e if income ↑ by 1%
how much will consumption inc.
A(bar) = autonomous consumption – when there is no income; func of accumulated wealth
c(MPC) lies b/w 0 and 1
Increase in c => AD curve becomes steeper || Dec in c => AD curve turns flatter
Change in A(bar) => Shift of the curve| A(bar)↑ then AD shifts upwards and Y ↑
Multiplier = (1/1-c) *A(bar)

Fiscal policy – (G, TR, TA)- used to stabilize economy

If G and TR are constant: TA = tY
C = C(br)+ c ( Y- TA + TR) = C(br) + c( Y- tY + TR(br))
Multiplier of Fiscal policy = A(bar)* (1/1-c(1-t))
Relation –

 t & Y is inverse
 c & Y direct
Taxes act as automatic stabilizer – by reducing multiplier => limiting fluctuations in o/t
Budget surplus = Taxes – Govt spending = tY – G – TR
BS is +ve when taxes < govt spending, -ve when Tax < Govt spending

IS curve ( invtmt saving curve) ( goods mrkt)

i is high => high cost of investment => low I (invtmt)
i is low => low cost of borrowing => high I (invtmt)
I & i has inverse relation (-ve)
I = I(bar) – bi , where b = sensitivity of invt to int rate
Y =AD = A(br) – bi + c (1-t)Y
Y = (A(br)- bi)* (1/1-c(1-t))
AS i ↑ then (a(br) -bi) ↓ hence Y↓ i.e GDP ↓ and vice versa
GDP and i has inverse relation
For each i there will be GDP, hence collection of these values gives us IS curve.
(for goods mtk)
If invtmt is very sensitive to int rate that is value of b is high then small change in i will lead
to large impact on AD.
Smaller the value of b => steeper the IS curve.
Impact of multiplier on IS curve
If alpha(multiplier) ↑ then Y will ↑ and GDP ↑ => Is curve becomes flatter.
For same int rate, ↑ in A(bar) leads to shift of IS curve
Fiscal expansion => shift IS to right
Fiscal contraction => shifts IS to left

LM curve ( money mrkt)

M/P – dmd for real balance
Dmd for money ↑ when the no. of goods we dmd ↑
Measures of Money :-
M0 – base money/Currency in circulation+ bank deposits with RBI + other deposits with RBI
M1- Currency with public + dmd deposits + other deposits with RBI
M2 – M1+ savings deposit with post office
M3 = M1 + time deposits with banking sys
M4 = M3 + all deposits with post office
L(dmd for real bal.) = kY – hi , where k is relation b/w Y and L and h is relation b/w i and L
LM curve - Combi of Y and i from money mrkt ; +ve relationship b/w Y and i (upward sloping)
s.t Ms = L
M/P
= kY – hi
i = (kY- M/P)/h – LM curve eqn
ME - ↑ in Ms => shifts Lm curve right => i ↓ => GDP ↑
MC - ↑ in Ms => shifts LM curve left => i ↑ => GDP ↓
FE – A(bar) ↑ => shifts IS curve right => i ↑ => GDP ↑
FC - A(bar) ↓ => shifts IS curve to left => i↓ => GDP↓
Change in Income will be less than Change in multiplier * A(bar) due to crowding out effect.

Monetary policy (RBI )

Goal – Maintain price stability and flexible inflation targeting (FIT)
WACR ( weighted avg call rate)- it is call money mkt rate – interbank transaction rate (also
called overnight lending)

Marginal standing Facility rate – rate at which commercial bank can borrow additional amt
(overnight) from RBI by dipping into their statutory Liq ratio (SLR) portfolio up to 1%.
Corridor – MSF and reverse repo rate determine the corridor for daily movement in WACR
RBI tries to make sure WACR is close to repo rate
Open market operations
1) purchase – Rbi buys back bonds - ↑ money supply
2) Sale – RBI sells bonds - ↓ money supply
Liquidity trap – Whem LM curve is almost horizontal => int rate will remain constant
Zero lower bond- hence the int rate can’t go further down bcoz there is no room to drop
the rate even if RBI increase money supply in the market. There will be no effect on int rate.
People will prefer holding their cash at this low int rate.
Monetary expansion –
OMP => Ms ↑ => i ↓ (LM curve shifts right) => Invt ↑ => AD ↑=> Y↑
Monetary Contractionary policy –
OMS => Ms↓ => i↑ (LM shift left) => Invt ↓=> AD↓=> Y↓
Fiscal expansion-
G ↑or T↓ => Y↑ => C ↑ => Y ↑ (IS curve to shift right ) => i↑ => I ↓(crowding out)
Fiscal contraction
When LM is horizontal, no crowding out becoz int rate won’t change

Fiscal & monetary effects

Shift of IS Shift of LM Movement in o/t Movement in int rate
↑ in T Left none Down Down
↓ in T Right None UP UP
↑ in G Right None UP UP
↓ in G Left None Down Down
↑ in M None Down UP Down
↓ in M none Up Down Up

Internal balance : GDP is full emp level (potential)

External balance : BOP is balance (=0)
Mundell flemming (Policy trilemma)
( exchange rate, perfect capital mobility, monetary autonomy)
Fixed ER

Beggar thy neighbor policy is when domestic depreciation of ER shifts dmd

from foreign goods to domestic goods- o/t and emp of abroad declines – bcoz
depreciation included change in trade bal
This policy is way of exporting unemp or a way of creating domestic emp at the
expense of rest of the world – simply a way of shifting dmd from one country
to another , rather than changing the level of dmd.