Transcription Doc

5.3.1

Note: This transcription document is a text version of the upGrad videos present in this session. It
is not meant to be read independently, but can be used to complement your video watching
experience.

Video 1

Speaker: Chris Oates

So, let's get started with just Macroeconomics. Why is it its own thing? Why do we separate
macroeconomics from the rest of econ or especially from microeconomics?

Well, imagine that you're owning a business. You, let's say own a factory and you take raw
materials, you hire workers, the workers do something with raw materials. They smelt it or
assemble it or do something else. And then the finished product, you go off and sell to your
customers.

Now, this chart that we have here, this little graphic kind of shows the basic principles, which I'm
sure you're aware of. You're a business. You have inputs, which is the money you get from
customers.

What comes into your business? You have outputs in terms of money, what you have to pay for
the materials, what you have to pay for labour. And that's basically how a business goes.

And you know, when you're trying to work on your business, you think about how your processes
are going, what your costs are, what's going on in your market, really. That's about how far you
often go into your landscape.

But if you were a finance minister, you're not necessarily going to care that much about that one
particular factory. You don't care that much about what that one business is paying for its labour.
You care about what all businesses are paying for all of their labour costs.

And you not only care about all businesses in one sector, you care about all sectors. Because as
we start to zoom out, and this is really the fundamental insight that leads us to study
macroeconomics as its own separate topic.

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As we start to zoom out from one business to the entire economy, things that to a business
person are separate, start to become connected.

And it's that level of abstraction where we're starting to focus on all households and all businesses
that allow us to see an economy as a whole, and also try to manage it. So, that's really what this
module is going to be about.

When looking at the economy as a whole, how should the government manage it when the entire
economy goes into recession?

How should a business think when they think the entire economy is really heating up or going
down? And what do these macro indicators have to do with things like inflation or interest rates or
employment.

Video 2

Speaker: Chris Oates

In this video, we're going to talk about the circular flow of income, one of the most important
concepts in macroeconomics.

Now imagine that you're a business, you have costs, labour, raw materials, and you have
revenues. Now you can put this all down on a balance sheet.

You can have your profits, you can have your losses, your costs, your revenues, but can you do
that for an entire economy?

We can't really say that an economy has a profit and loss table. But what we can do is try to track
how income flows around in an economy.

Now, let's imagine that we have a very simple economy. There are households and there are
businesses. So, a two-sector model of the economy.

Now, how does that money flow? How does money flow around there? Well, pretty simply,
households or people will spend money on products and goods and services.

So, households send money into businesses in exchange for products and services. Businesses,
which have workers, well they send money to people and households through wages and salaries.

Now, of course, we know that there is no economy that just has households and businesses.
There are other things going on to it.
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So, let's add to this model and you can see in the diagram over here, we're adding government to
it because every economy that exists has a government that is somehow overseeing it in some
ways.

And these households and businesses will pay taxes to the government. And in exchange, they
will receive either subsidies or goods and services, or the government will pay its employees. And
so paying households or the government will buy things from businesses.

You know, the government will buy food for its offices, or it will buy construction services to build
new buildings.

So, in a three-sector model of the economy, we have households, businesses, and governments.
And there's a flow of money between all three of them, in exchange for goods or services or
labour.

But now let's add one more element to it because we know that there's no country that exists fully
in autarky. So, let's add foreign trade to it.

Now, when you have foreign trade, households might buy goods from abroad. So, there's going to
be a flow of money from households to a foreign trade sector.

Businesses will also import goods from abroad. So, they'll be sending money to the foreign trade
sector in exchange for goods coming to them. And businesses will also export goods to the foreign
sector and exchange, they'll get money to that.

So, from the country to the foreign sector, there will be money traveling from the foreign sector to
households, from households to the foreign sector, and to and from businesses.

So, what does that all mean? And as we can see in this graphic here, we have a diagram with four
different sectors. There's a lot of arrows going back and forth to indicate how money flows. What
does that actually mean? And why do we have that?

Well, the reason we have is that this circular flow of income travels around, starts to model how
an economy might function.

And the reason we have this is because as we said, we can't simply say this business pays these
workers, it's too complex and too big for that. So, we abstracted out to these sectors.

And by doing so, we can start to model what is going on with an economy when things start to
happen. Because obviously there is no economy that is purely stack. We could imagine that
there's a flow of income around an economy, but that could grow or shrink.
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We know that economies grow and shrink. And what this circular flow of income allows us to do is
to conceptualize how that process might actually work.

So, imagine how might this circular flow of income increase? How could we get more money into
this system than currently exists?

Well, there are a few different ways that money could be injected into this system. You could
have investment. So, let's say businesses have been sitting on capital and decide that they're
going to build new factories. So, they're going to invest that money into the economy. That is new
money going into this flow of income.

You could also have government spending. The government might spend more money than it
raises in taxes. And so, there'll be additional money coming into their system.

You could also have a large increase in exports, so that foreign trade sector is sending a lot more
money into the system than it previously had been.

And of course, there's also ways to remove money from the system, to make the flow of income
floating around the system decrease.

You could have savings. So, households especially might start saving money that they earn and
not put it back into the system. You could have the government raising taxes without a
commensurate rate increase in spending.

Or you could have a lot of imports. So, households and businesses might start importing a lot
more, meaning that while they're getting a lot more goods and services from abroad, they're
sending money out of that system, that money will no longer be able to flow around the system.

Now, how does that look like in real life? What is a real-world example of this circular flow of
income? Well, let's take the example of North Dakota.

It's a state in the United States that after the global financial crisis had a huge jobs boom, in part
led by the shale revolution, the hydraulic fracturing technology that allowed companies to get a lot
more oil out of existing reserves. And some of those reserves were beneath North Dakota.

So, at that time, there was a lot of activity in the oil sector, and there were new fields that were
being drilled. Meaning that businesses were investing more into the North Dakotan economy.
That's an injection of capital into that economy.

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There were households who were moving to North Dakota and then being able to spend money.
So, they were able to both earn money and spend money that previously hadn't been spent in the
state.

The government was spending a lot more because there were more people. And also, the
government was getting money from oil revenues.

But most importantly, in this case, there was a lot more exports. North Dakota was drilling a lot
more oil than it could consume itself. So, it was exporting to the rest of the country and at parts
to rest of the world.

Now that meant that there was oil and natural gas and other petroleum products going out of the
States. And there was money coming in.

So, as that money came in, as there were a lot more exports, this flow of income increased as
that money got injected into the system.

Video 3

Speaker: Amrita Bhattacharya

Typically, economists measured the size of an economic in terms of its gross domestic product,
which is the GDP.

GDP is the core barometer for measuring the economic health of a country. It is extensively used
to measure the economic growth and purchasing power and the overall economic clout of a
country.

When you hear people talking about a shrinking economy or an economy being stronger than
another, they're usually referring to the country's GDP figures. These figures are especially
important when businesses decide about investing in other countries.

Simply put, GDP is the value of all final goods and services produced within a country each year.
So, the measurement of GDP would involve counting the production of millions of various goods
and services produced within the country and summing them up into a single rupee value.

Let's now look at the formula for calculating GDP. It is, GDP equals to C plus I plus G plus X minus
M, where C stands for total consumption, which is the household spend and also the consumption
by the governments and other entities.

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I stand for investments, which could be in the form of businesses making capital expenditure or
people buying homes, etc.

G for government spending, X for exports, and M for imports. Note that the X minus M value
indicates net exports. From the formula, you can see that if a country imports in very high
volumes, it's GDP would decrease.

There are generally two ways or approaches to arrive at the GDP of a country, Expenditure
approach and income approach. These are based on the simple accounting principle that all
expenditure in an economy should be equal to the total income generated by the production of all
economic goods and services within a year.

Therefore, by summing up all the income sources, we can provide a fairly accurate reading of the
total productive value of the economic activity within a country.

Now, the expenditure approach involves calculating and summing up the money spent on the
factors discussed in the GDP formula in a given time period.

This would include how much people spent on household goods, how much the government
spent, how much the businesses invested and what was the value of net exports.

The income approach on the other hand takes into account the final income received by the
residents of a nation. It would include the salaries, wages, reigns, corporate profits, etc.

Naturally, going by the circular flow of income in an economy, the results obtained by both these
methods should be equal. However, of the two approaches, the expenditure approach is more
widely used and cited.

Now let's take the example of the automobile sector in India, it's connection with the GDP
numbers. This sector shows a slowdown in 2019, but this decline did not result from any issue
within the auto sector.

Demand for automobiles dropped sharply, and the people were just not willing to spend money on
buying cars. This low down can be ascribed to the decline in the country's GDP, which means
there was less money in the economy.

So, even though there were cars for sale, there were no takers. GDP can also be calculated in two
terms, nominal and real terms.

In the formula we just discussed, the GDP was calculated in nominal term., Nominal GDP also
known as the current dollar GDP is a measure of the value of all final goods and services produced

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in a country at current market prices, not adjusted for inflation. Real GDP on the other hand is
adjusted for inflation or deflation.

Before moving ahead, let's look at two other times that you should know about, which are the
gross national product or GNP and the net national product or NNP.

GNP is the sum of all countries GDP plus income from abroad. This foreign income can include
remittances, trade balances, which we will cover in a later session, and interest on external loans.

Whereas GDP measures total income produced domestically in an economy, GNP measures the
total income earned by nationals, including those living abroad. It is a good indicator of how an
economy is functioning overall.

The net national product refers to GNP minus depreciation or GDP plus income from abroad minus
the depreciation.

Here, depreciation refers to the loss of value of fixed capital or assets resulting from wear and
tear over the course of use. This figure is important in measuring an economy's success in
maintaining the minimum production levels.

Video 4

Speaker: Chris Oates

One thing you might be wondering is, okay, we have a certain flow of income. We can measure
that with GDP, but what makes certain countries richer than others?

Now, we obviously know that India is richer than Afghanistan on a per capita basis certainly, but
poor than the United States. But what makes that happen? What makes a country have a certain
amount of income flowing around its system and others have much less or much more?

One of the most important measures of an economy is its productivity. And in the long run,
economic activity and productivity are basically the same.

Productivity is how much value a worker can produce in an hour or in a year or in a month,
however you want to measure it.

But it's the idea that, you know, on a personal level, if you're a film star who can work for a
month and make a million dollars on a film, you have been much more productive than a farmer
who works for a month and produces a thousand dollars’ worth of crops.

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Now it's not to say that one is working harder than the other, but in terms of the effort they put in
and the money that comes from that, one is much more productive than the other.

And when we go to the national level, we can see that some countries are much more productive
than others in the sense that their workers will work for a certain amount of time and produce a
lot more stuff of monetary value.

So, how are countries productive? How can we say that the average worker in one country is
much more productive than the other, if they are working just as hard?

Well, countries are productive if they're better able to utilize their physical capital, i.e., the stuff
that they have in their country, their roads, their ports, their buildings, their human capital.

So, the ability of their people to produce stuff, their natural resources and their technological
knowledge.

And if they're able to combine these assets, these physical capitals, human capital, natural
resources, and technological knowledge to produce a lot of stuff of value in a short amount of
time, then they would be much more productive and therefore richer.

Now let's just take the example of Qatar as an extreme example. Now, Qatar is the wealthiest
country on a GDP per capita basis, at least according to the international monetary fund.

And one reason why is that they have huge natural gas reserves. And that is a relatively easy
thing for a worker to exploit if you have the right physical capital.

Meaning that you have the oil rigs, if you have the right human capital, meaning that you have
engineers, you know how to work those rigs, if you have the natural resources which they do and
which you need to exploit to begin with, and if you have the technological knowledge, so you
know how to build those rigs, you know how to build the pipelines, but they produce a lot of
natural gas and you can sell for a lot of money on world markets.

Well, then you're a very productive country because you're able to generate a lot of income with
not a lot of workers.

We see this in a number of industries. We see this with automation in factories. They become
much more on a per worker basis when machines start doing more products.

We see this with technology companies. Facebook, Google, Apple produce a lot more revenue on
a per worker basis than some other companies in other sectors do.

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So, as a country better utilizes its physical capital, human capital, natural resources and
technological knowledge, or as it grows them, it's able to be more productive on a per worker
basis, and therefore generate more wealth on a per worker basis, and therefore become a richer
country in the long run.

Video 5

Speaker: Chris Oates

So, one of the most important questions any business asks of an economist is whether there's
going to be a recession.

And probably the most important thing for business to know is whether demand is going to dry
up. And I won't be able to sell my products and I'll have to cut staff. So, how do recessions
actually happen?

Well, if we think back to the circular flow of income, the flow of income will decrease, if for some
reason there is a leakage from the system.

So, income flows out of the system. The overall amount of income will decrease. That is how we
can conceptualize a recession. It's the amount of income in a country going down.

Now, how might that happen? Well, there are a lot of ways it could happen. But one is through a
demand led recession. That means that the demand in an economy is for some reason being
reduced.

And we have a few of the most possible ways. Here, the households might decide to save more
money. There was a pandemic that means they are afraid of losing their jobs.

You could also have a surge in imports. A lot of money is leaving the system because people start
to import more. Maybe businesses are investing less. Maybe government is taxing more. These
are all ways that the amount of money in that system could decrease.

We could also have a supply led recession, especially a supply shock. Imagine if the price of oil
doubled overnight.

Now, if you're a country, that's an oil importer as India is, then you would be spending twice as
much money for what you're reporting. In other words, the money that is going out of the system
and to pay for your imports is now doubled.

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Now, maybe you don't want to spend that much money, so you just cut your imports in half, but
then you have half as much oil in your economy.

And you can imagine that if oil was halved overnight, there'd be a lot less deliveries made. There'd
be a lot less factories opening, or maybe if they were made, you have to spend more money on
them and that would leave less money for everything else.

Then you have to cut wages because you have to pay more for the oil, for the petrol, for the
trucks and your delivery fee.

So, anything basically that would interrupt the normal course of business, that would lead to less
materials being available to businesses could be considered a supply shock.

And generally speaking, one way to think about a recession is that anything that would interrupt
the normal course of an economy, the normal flow of income in a severely negative way could
cause the amount of money in a system to drop, and therefore the economy goes into a
recession.

Video 6

Speaker: Chris Oates

In this segment, we're going to talk about two models that are at the heart of modern
macroeconomics. And that are really important to keep in mind, especially as we move on to the
next session, where we're going to be talking about important theories and factors.

And those two models are aggregate demand, aggregate supply, and ISLM or investment savings,
liquidity preference, money supply.

Let's start with aggregate demand, aggregate supply. We have a graphic here that can start to
illustrate it. And in this graphic, we see on X axis, output or GDP or economic activity, on Y axis, a
price level, so that's the prices in an economy.

And then we have two slopes, aggregate demand and aggregate supply. And these are very
similar to your normal demand and supply curves that you see in microeconomics.

So, as the prices drop in an economy, demand will increase more because as prices drop, more
people want to buy that stuff. And so, demand increases and it increases the economic activity.

Supply is the reverse. As prices increase, businesses want to sell more and more. And so, their
economic activity would go up.
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And then where those two slopes intersect is where we get our equilibrium. It's where we get the
prices that exist in the economy and the amount of buying and selling that happens in the
economy. In other words, the economic activity.

Now this model is actually really useful for understanding recession. So, I said in the last video
that recessions can be a demand or a supply led recession.

Let's focus on demand led recessions here because they're often what happens most of the time,
or at least once you're in a recession, they become probably the bigger issue.

So, let's say that for whatever reason, demand in an economy shrinks. So, this curve is going to
shift to the left. And as we see we it goes from 81 to 82, there's now less demand in the
economy. So, there's less economic activity. But also, there are lower prices.

So, the slopes of supply and demand will intersect at a lower price point and at a lower economic
activity point. And that makes sense if you've ever lived through a recession, you know that there
are workers who are willing to accept lower wages, businesses need to get rid of products that
they can't sell at the same prices. So, they cut prices.

So, in a recession, you see prices fall, but you will also see economic activity fall. Now what should
happen in a recession, and if the market were purely self-correcting, is that supply would start to
adjust.

So, supply would adjust since you have lower prices, maybe supply drops a little bit more, and we
go from AS1 to AS2. And so, economic activity returns to the same position, but with much lower
prices.

And in that case, you would see, you know, businesses start to adjust, consumers start to adjust.
And especially if you're thinking about the long run effects of a recession, and if the economy
really were correcting in the long run, this is where you should get to it.

Or if you had supply constraints, you know you had a long run aggregate supply constraint, this is
where you would start to see the equilibrium.

Video 7

Speaker: Chris Oates

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Let's move on now to the ISLM. Now this stands for investment savings, liquidity preference
money supply. So, if we look at the graphic here, on the X axis, we again have output or
economic activity or GDP. And on the Y axis, here we have interest rates.

So, this is the price effectively that you get paid for saving your money. So, if you invest your
money in the stock market, or you put it into a bank account, this is the interest rate that
someone will pay you to save that. Or it's the price that you get charged if you want to borrow
money.

So again, we see that as interest rates go down, there is less preference for savings and people
want to invest that money since you're not getting a very good interest rate.

So, as the interest rates go down, the savings preference goes towards more economic activity,
basically injecting it back into the system rather than just saving it.

And as rates go up, people want to supply more money for savings. You know, if interest rates
were 10% and you were debating between buying a new car or saving it, if maybe you say, well,
I can get a 10% rate of return on this investment, I'll save it.

And if you got maybe only a 1% interest rate and you think, well, I'm not really getting much
money if I save it and it's a new car, that's kind of nice. So, I'll spend it.

So, the kind of supply of liquidity, or money for investment goes up as the interest rate goes up,
and economic activity would go up in that situation.

This model is really useful, not only for understanding where the natural interest rate would be, or
the equilibrium interest rate would be at the current levels of economic activity, but it can also
help demonstrate what happens when the money supply changes.

So, we assume that investors have a preference for more liquid assets. You want to be able to
access your money if the opportunity for a good investment or good purchase comes up, you
don't want to lock up your money long-term.

But obviously this depends on how much money there might be in the system. Because if there's
a lot of money floating around, then liquidity preferences might change a little bit.

Now we're flagging these two models right now. Aggregate demand, aggregate supply and ISLM,
not because we expect that you are going to immediately go out and start calculating these
things, and that in your business operations, you're going to be drawing these charts every day to
try to figure out what's going on.

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Probably in your business life, you will never need to actually calculate this model for an economy
that you're working in.

But we're mentioning them because these are at the heart of much of what we're going to talk
about throughout the rest of the module, trying to understand what's going on in aggregate
supply, aggregate demand. During a recession, for example, is a great way of understanding why
a government might be taking the policies it is.

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