MTP

SESSION 3

Reading
1. This set of slides
2. Class Notes
 Mar Jun Sep Dec
‘21 ‘21 ‘21 ‘21
AS of AS-
1200 2
AS- AS-1 < AD-2 AS of
produced 1 AS increases to 1320
and sold catch up to AD-
Income produced
disbursed 2 and sold
to AS
household catches up
Is AD = AS ? Income AD- Suppliers
with New
AD
Or Is AD ≠ AS? used by
household Money New
2
AD try to
supply
AS tries to catch up to used by of 1320 according
AD.
Money Govt., FI, generated to their
received and
estimated
by Govt., Foreign
AD
FI, and sector.
Foreign
sector.
 Yes, if measured in the same year.

Is Also, there is a way to match the two.

GDP (income approach)
= By defining investment appropriately.
GDP (expenditure
approach)?
S = Savings
= income earned but not spent

I = Investment
= addition to capital stock
 Investment
Fixed capital formation
= creation of new capital goods
Gross capital (also called nonresidential investment)
formation

Net acquisition of valuables

Investment
Spending (I) or = Jewelry / works of art / property etc.
Gross Investment (also called residential investment)

unsold items (final or intermediate)

Change in
inventories
(Can be positive or negative)

https://en.wikipedia.org/wiki/Gross_private_domestic_investment
https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=13552
I or Gross Investment has 2 alternative definitions.

1st, I1 = Gross capital formation

2nd, I2 = Gross capital formation + Inventories

The Aggregate Output and Definition of investment (I1)

Aggregate supply of goods and services (AS)

= Value of goods and services produced in the economy
= ∑PiQi [where i is a final good]
= Σ Value added in all sectors
= W + int + P + R
= Aggregate Income generated for the people (Y)
=C+S+T

Aggregate Demand for goods and services (AD) Here I = Addition to capital sock (I1 : gross
= Total Expenditure made on firm’s produce capital formation)
= C + I1 + G + X - M
AS = C+S+T may be > or = or < AD=
C+I1+G+X-M

If AS = AD somehow, It is an equilibrium.
The Aggregate Output and Definition of investment (I2)
GDP measured by Income approach
= Aggregate supply of goods and services (AS)
= Value of goods and services produced in the economy
= ∑PiQi [where i is a final good]
= Σ Value added in all sectors
= W + int + P + R
= Aggregate Income generated for the people (Y)
=C+S+T

GDP measured by Expenditure approach

= Aggregate Demand for goods and services (AD) + inventories
= Total Expenditure made on firm’s produce
= C + I2 + G + X - M Here I = Addition to capital sock + Inventories (I2)

GDP (Income approach) = C+S+T = GDP (Expenditure

approach) = C+I2+G+X-M
Always.
AS = AD + unsold inventories

C+S+T = C+I1+G+X-M + unsold inventories

C+S+T = C+G+X-M + I1+unsold inventories

C+S+T = C+G+X-M + I2

C+S+T = C+I2+G+X-M

GDP(income app) = GDP (Expenditure app)

 AS = Total income earned by individuals = C + S + T
AD = Total expenditure made on firm’s produce = C + I + G + X –
M

If AD = AS then it is an equilibrium in the goods market.

In equilibrium, AD = AS
Equilibriu So, C + I + G + X – M = C + S + T (Here I = I1)

m In absence of the govt. and external sector, in the current year

C+I = C+S
Or, I=S
Suppose, this year’s savings are not entirely invested.
What will happen to the GDP in the next year?

Thus S > I
→ C+S>C+I
→ AS > AD
→ Demand for domestic goods and services is reduced.
→ Output will fall.
→ Recession

If S = I, output will remain at the current level.

S=I implies output is in equilibrium.
In presence of govt. and external sector,
C+I+G+X–M=C+S+T

Or, S = I + G-T + X-M

Domestic saving has three uses.

1. Private investment I
2. Financing budget deficit G – T
3. Lending to the foreigners to finance their trade deficitX - M
Suppose, the entire household savings is
invested in private business. The government
also runs a deficit in the budget.
What can you infer about the country’s external
economic linkages if the economy is in
equilibrium?
S = I + G-T + X-M

S=I
Either G - T = X – M = 0
or G – T > 0. Budget deficit must be financed by external borrowing.
and X – M must be < 0
That is, import bill M > Export revenue X
→ Trade deficit
→ external borrowing to finance trade deficit , as well.
China,
its current China has a large current account surplus.
account surplus
and Can the Chinese government finance its budget deficit
with the current account surplus?
budget deficit
financing Can any government use current account surplus to
finance budget deficit?
 China’s Current account

China’s Government
Budget
Say X-M is a large positive amount.
It is earned by the trading firms as foreign currency or $.
These firms exchange the $, to get domestic currency, High X-M
from the Central Bank. So some $ accumulate at the central
bank. And some extra domestic currency accumulate with Firms earn income Central Bank
earns $
the public.
C↑ S↑ T↑
The public can raise (a) Consumption or (b) Saving with
this extra money. The government may impose (c) Taxes Past loans
Sales tax Budget of the
too. collection deficit ↓ governmen
↑ t paid back
• If consumption is raised it stimulates demand. But
government cannot use the money to finance its deficit. Govt.
(govt. may get some extra taxes) Can
• If savings are raised, the government can float bonds borrow
to
and borrow from the public to finance the budget
finance
deficit. Note this does not reduce the budget deficit, but Budget its
only provides a way to finance it. deficit ↓ spending
• If taxes are raised, and the government is successful in
collecting more taxes, the deficit is reduced.
• The foreign exchange accumulated with the central
bank can be used for paying back the foreign loans
accumulated to finance the budget deficit.
Exercise

If our exports are $1.2 billion and our imports are $1.7 billion, and the
government has a budget deficit of $ 3 billion, national savings $6 billion and
private investment $4 billion. Is the economy expected to grow in the near
future?
S=6
I=4
G-T = 3
X-M = -0.5
S < I + (G-T) + (X-M)
Or S+T < I + G + X-M
Or C +S+T < C + I + G + X-M
Or household's income last period < expenditure on firms this period
Therefore firms can earn higher revenue this year compared to last year. So
households can also earn higher income next period from the firms.

Hence growth is expected.

Exercise

Which of the following are included and which are excluded in calculating this year’s GDP?
Explain your decisions.
 
a. A monthly check received by a student who has been granted a government scholarship.
b. A farmer’s purchase of a new tractor.
c. A plumber’s purchase of a used truck.
d. The selling of a U.S. government bond that you held for the last few months.
e. The services of a mechanic in fixing the radiator on his car.
f. A Social Security check paid by the government to a retired store clerk.
g. The government’s purchase of a new submarine for the Navy.
h. A barber’s income from cutting hair.
i. Income received from the sale of Nike stock.
Solution
a. A monthly check received by a student who has been granted a
government scholarship.- NO. This is a government transfer.
b. A farmer’s purchase of a new tractor. – YES
c. A plumber’s purchase of a used truck. – NO, old good’s transaction.
d. The selling of a U.S. government bond that you held for the last few
months. – NO, no production only financial transaction.
e. The services of a mechanic in fixing the radiator on his car. NO – it is his
own car. So its not a recorded market transaction.
f. A Social Security check paid by the government to a retired store clerk. -
NO. This is a government transfer.
g. The government’s purchase of a new submarine for the Navy. YES
h. A barber’s income from cutting hair. YES
i. Income received from the sale of Nike equity stock. – NO, no production
only financial transaction.