Basic concepts used in Macroeconomics

(Lesson - 3)

TITLE

Basic concepts used in Macroeconomics

Lesson - 03

COURSE NAME

Principles of Macroeconomics – I

COURSE (as per CBCS)

Semester - III

Introduction

Some of the basic concepts that are frequently used in macroeconomics are as
under:

1. Variables
A variable is a quantity or magnitude which can be measured on a scale
and which varies. If a quantity assumes different values, indicating
continual increase or decrease, it is considered as a variable. Variables can
be classified into four categories. They are described below:
a) Dependent and Independent Variables
A variable is a dependent variable if its value depends upon the value of
some other variable. We know that C = f (Y), consumption is a function
of income. Consumption of an individual is a function of the income of
that person. There is a positive relationship between consumption and
income. With rise in income, consumption rises and with fall in income,
consumption also falls. Here consumption is a dependent variable and
income is an independent variable. In law of demand we study the
relationship between price of a commodity and its quantity demanded.
Qx = f (Px)
Here, quantity demanded is a dependent variable and price of the
commodity is an independent variable. There is inverse relationship
between price of a commodity and its quantity demanded.
However, these relationships between dependent and independent
variables hold good only in the relative sense, not in absolute sense. For
example, output varies with employment. Here output is a dependent
variable and employment is an independent variable. But where
employment itself depends on other factors such as wage rate,
investments and technology etc., employment is to be treated as a
dependent variable.
Similarly in case of law of demand, price is an independent and demand
is a dependent variable. But when we talk of determination of price on
the basis of demand for and supply of a commodity, price becomes a
dependent variable.

b) Endogenous and Exogenous variables

Actually the endogenous and exogenous are botanical terms.
Endogenous is related to internal growth while exogenous is related to
growth or addition from outside.
A model is a system of equations. If the variables are internal and form
an integral part of the system, they are known as endogenous variables.
On the other hand, if variables are external to the system, they are
called exogenous variables or parameters. Dependent variables are
always endogenous. Exogenous variables may be either non-economic
or economic in nature and are determined independently by the system
or model. There is no hard and fast line of demarcation between these
variables.
For example, levels of income, output, employment, savings and
investments are endogenous variables. But variables like the size of
population and composition, imports, techniques of production,
inventions and innovations may be regarded as exogenous variables.
However, it is possible that some variables at different times and under
different circumstances can be treated differently. For instance,
technological inventions and innovations are generally regarded as the
exogenous variables, but if the initiative for these changes takes place
due to agricultural or industrial development, they are the outcome of
economic compulsions within, then they are to be taken as endogenous
and not exogenous. It is always easier to understand a macro-economic
model if one carefully distinguishes between the exogenous and
endogenous parameters. The purpose of the model is to explain how
exogenous variables affect endogenous variables.
 Illustration 1. Shows that exogenous variables come from outside the
model and serve as the model input, whereas endogenous variables are
determined within the model and are the model's output:

Exogenous Models Endogenous

Variables Variables

Illustration 1. Exogenous variables affecting Endogenous variables.

In demand function
Q = a + b p....... (i)

........ (ii)

In the equation No. 1, demand is endogenous variable and price is

exogenous variable. In contrast, in equation – (ii), demand is exogenous

and price is endogenous.

 D2

D1 D

Price

D2
D1 D

0 Demand X
Fig. 1

In fig. 1 DD is the first demand curve. But if other factors like income of
the consumer, taste and preferences, price of related goods,
population and price expectations change, demand curve shifts to the
right or to the left depending upon whether demand increases or
decreases at the same price. So the above mentioned variables are
exogenous variables.

Thus we can find out which is the endogenous variable and which are
the exogenous variables in any model. Exogenous variables affect
endogenous variables but they are not affected by endogenous
variables.

c) Stock and Flow Variables

Stocks and flows are both variables; they are quantities that may
increase or diminish over time. The distinction between them is that a
 stock is a quantity measureable at a specified point of time whereas a
flow is a quantity that can be measured only in terms of a specified
period of time. For example, you were having Rs.10,000/- in your
savings bank account on 1st January, 2017 or on 11th March, 2017, there
were 8000 cars in a car factory. Both of these are examples of stock as
they refer to a specific point of time. If you are depositing Rs.1,000/-
every month in your recurring account or you are getting 8% annual
interest on your deposits, all these are flow variables.

Money is a stock but spending of money is a flow. Some

macroeconomic variables that have flow magnitudes also have direct
counterpart stock variables. However, others such as imports and
exports, wages and salaries, tax payments, social security benefits and
dividends are only flows. None has a direct stock counterpart.

Table 1 Stock and Flow Variables

Stock Inflows Outflows

Inventory Incoming Goods Outgoing Goods
Population Birth & Immigration Deaths and Emigration
Real Balance Deposits Withdrawals

Flow Stock Flow

Illustration 2 Causation Process

Electric fan is a stock, but its speed is a flow. Money is a stock but
expenditure is a flow. Wealth is a stock but income is a flow. A flow
changes the stock over time. Increase in bank deposits increases the
monthly interest income. Thus stock also affects flows:
d) Ratio Variables
 There are certain variables which do not have either the stock
dimension or flow dimension.
A ratio variable expresses relationships between two stocks or two
flows and between stocks and flows at a certain point of time. For
example, since price does not need a time dimension it can be treated
as a ratio between two flows, namely a flow of cash and a flow of
goods. In the ratio, the time appears both in numerator and
denominator and hence cancels out.
Examples
i) Relationship between stocks: liquidity- percentage of liquid assets
to total assets of a person.
ii) Relationship between flows: Ratio of saving to income
iii) Relationship between a stock and a flow: velocity concepts- flow
of money transactions or income and a stock of money.
e) Time series and cross section analysis
Economic data can be classified into time series data and cross section
data. If the data concerning a particular variable is obtained from a
specific entity for several time periods, say, quarters and years, it
constitutes a time series. Malthusian theory of population is based on
decennial time series data pertaining to population and food supply.
On the other hand, a cross section analysis is based on the statistical
data from various cross sections of the society at the same time. The
cross section may be individual families, or firms, consumers, producers,
industries and geographical subdivisions. For example we want to see
the effect of a government’s policy on different states but in the same
time.
 Some economic analyses are based on the combined cross section and
time series data. The combined data are called pooled data. The pooled
data analysis is better than either of economic analysis based on cross
section data or time series data.
f) Ex-ante and Ex-post Analysis
There two terms are mainly used in the context of saving and
investment. They were initiated by Swedish Economist of Stockholm
School. Ex-ante variables are the intended, planned or desired variables
at the beginning of the specified period. Ex-post variables are the actual,
realized or observed variables at the end of a specific period. Because of
the time lag between the two, ex-ante values may be different from ex-
post values. Ex-post saving and investment are always equal while the
ex-ante saving and investment are not necessarily equal.
g) Functional Relationship and Parameters
There is a functional relationship between two variables when the value
of one depends uniquely on the value of the other. Demand schedule in
microeconomics involves two variables- demand and price. It depicts a
functional relationship between the price of a commodity and its
quantity demanded. Symbolically it is expressed as:
Dx = f (Px)
When Px is the demand for commodity X, Px is the price and f indicates
function of
Actually demand for a commodity depends upon many other factors
like income of the consumer, price of related goods, tastes and
preferences, expectations etc. All these variables are assumed to be
constant to find out the relationship between price of a commodity and
its quantity demanded. Constant variables are called parameters. If any
 of the parameters changes, demand curve will shift. Thus function
changes whenever there is change in any parameter.
h) Identities and Behavioural Relations
Identities
Identity implies a simple mathematical and abstract truism. If the
relationship is assumed to be true, by definition, it is called an identity
or an accounting relationship. For example, MV PT where MV stands
for supply of money and PT stands for demand for money. So MV PT
merely expresses a truism and the equality between MV and PT holds
irrespective of the changes in their respective values.
Behavioural Relations
The behavioural relations are not mere truism. There can be proved or
disproved through empirical testing. Such relationship may be
expressed in the form of equation and may be denoted by the symbol
“=”.
For example, we consider the consumption function
C = a + by

Here "C" refers to consumption spending, "a" is a positive constant; it

refers to consumption spending at zero level of income."b" is the ratio of
change in consumption to change in income ( )."b" is also called
marginal propensity to consume (MPC). This consumption function
equation has been arrived at on the basis of empirical studies about the
behaviour of consumers in the society.

Summary
 In this lesson we have discussed what is a variable; what is the
difference between dependent and independent variables. The value of
a dependent variable depends upon the value of independent variables.
Endogenous variables are internal to the system and exogenous
variables are external to the system. We have also discussed about
stocks and flows. Stock always refers to a specific point of time and flow
refers to a period of time. We have also mentioned ratio variables which
have neither stock dimension nor flow dimension. Time series and cross
section analysis have also been discussed. In time series we take data
relating to variable over a period of time; in cross section we take data
related to a variable and related to different sections of the society at
the same time and combination of these two is the pooled data. Then
we discussed ex-ante and ex-post analysis. Ex-ante is planned or desired
value of the variable while ex-post is at the end of the period which is
actual or the realized one. Functional relationships and parameters have
been made clear to you. The factors which are taken to be constant in a
function, are called the parameters. The relationships which are there by
the means of definition they are called identities and behavioral
relations are actually the tested one. They are empirically found that this
relationship exists. When we find what is the actual relationship
between consumption and income, then it becomes behavioral relation.