Macroeconomics

Evaluation Pattern:

 Internal Continuous Assessment (ICA) 50 marks

 Mid term exam: 20 marks
 Quiz: 15 marks
 Project Report/Presentation: 15 marks
 Term End Exam: 50 marks
 Course Outline:

 Module 1 : Introduction
 Module 2: National Income and its determination
 Module 3: Classical Model of Income Determination
 Module 4: Keynesian Model of Income Determination
 Module 5: Analysis of the monetary sector
 Module 6: IS-LM Framework
 Module 7: Inflation and unemployment
 Module 8: Open economy
 Microeconomics vs Macroeconomics:

 Microeconomics is that branch of economics which analyses the market behaviour and decision-
making process of the individual consumers and firms and also the interactions between individual
buyers and sellers.
 Macroeconomics, on the other hand, is the study of how the national economy as a whole grows and
the changes that occur over time .
 Thus, it analyses the big or the macro picture.
 Hence, the basic concerns of macroeconomics are to measure as to how well an economy performs,
works, and then try to improve the performance of the economy.
 Background of Macroeconomics:
 Macroeconomics is the study of how the national economy as a whole grows and changes, which
occur over time.
 The origin of macroeconomics can be divided into three stages:
 Classical School of Thought: Adam Smith (1723-1790)
 David Ricardo, James Mill, Alfred Marshall, J.S. Mill, Pigou and Edgeworth.
 Keynesian Economics: (John Maynard Keynes (1883 -1946) )
 General Theory of Employment, Interest and Money
 US Great Depression (1930s):
 Response of classical School: Full employment was the normal situation.
 Departure from full employment would temporarily occur.
 The automatic forces present in competitive market would push the economy back towards full employment equilibrium.
Contd.

 Keynes’ general theory was an alternative theory.

 It explained the determination of employment and output, and also the
explanation as to why the market forces in an economy would not
automatically generate a level of aggregate demand which was required
for full employment.
 Keynes’ theory addressed the issues pertaining to the economic disaster
in the form of the Great Depression and provided an explanation for this
disaster.
 Contd.

 In this new theory, Keynes had developed an analysis as to

 What causes unemployment and the downturns?
 How the consumption and investment levels are determined?
 How a central bank manages the money and the interest rates in an economy?, and
 Most important of all as to why some nations prosper while others stagnate.
 The various restrictive policy measures, recommended by the Keynesian theory, were not
successful in checking the inflation and, in fact, responsible for pushing the US economy
towards a recession in 1970, which was later followed by double digit rate of inflation that
gripped the US economy.
Contd.

 In such a situation, Keynesian economics, where the tools were designed for
the specific purpose of controlling aggregate demand, could not provide a
solution to the problem of controlling inflation and a recession, simultaneously.
 This was followed by the development of what is called the supply side
economics.
 Macroeconomics deals with big issues like price stability or inflation and full
employment or unemployment.
 Contd.

 The Post Keynesian Economics:

 Starting in the 1950s and continuing till today is the development of another
extension of the classical theory, which assigns a very critical role to money as a
major factor in determining whatever happens in an economy.
 The theory is known as the monetarism.
 In fact in the 1960s and the 1970s, the theory gained so much importance that it
was thought to be a counter-revolution.
 Monetarists like Milton Friedman were responsible for making the theory popular
worldwide.
 Contd.

 In the 1970s, the classical theory took a new turn with the introduction of the
concept of rational expectations.
 This was the latest theoretical development on the classical front whose roots
were firmly embedded in the classical theory.
 The emphasis here was on the role played by the individual’s rational
expectations regarding future economic events.
 Contd.

 Need to study macroeconomics:

 From the viewpoint of an individual.
 From the viewpoint of consumers, firms and governments.
 From the viewpoint of an economy’s performance.
 From the viewpoint of an economy’s stability and growth.
 Macroeconomics helps to evaluate the performance of the economy, in terms of
the national output, the rate of unemployment, the inflation rate and the trade
performance.
Concepts in Macroeconomics:

 Stocks and Flows:

 Both stocks and flows are variables.
 Both are quantities that may increase or decrease over time.
 However, there is a difference between them, stock is a quantity measured at a
point in time where as flow is a quantity measured over a period of time.
 Some macro stock variables are the money supply, the total number of people
employed in an economy, the total stock of capital, the total labour force, etc.
 Some macro flow variables are the savings, investment, change in inventories,
change in the money supply, etc.
 It is important to note that often stock and flow are related.
Contd.

 This is because a flow is actually the change in the stock.

 For example, while the total number of people employed in an economy is a
stock variable, the numbers of people who take up new jobs or leave jobs are
flow variables.
 While money is a stock variable, the expenditures in money or the spending
of money is a flow variable.
 While inventories is a stock variable, the change in inventories is a flow
variable.
 Contd.

 While a change in stock occurs due to a change in the flow, a change in flow may
also be influenced by a change in the stock.
 For example, a change in inventories is brought about by many factors including
a change in the stock of capital.
 An excessive stock of capital may necessitate a decrease in the flow of
investment and may thus be responsible for a business going downhill.
 However, it is important to note that stock can influence flows only in long run.
Contd.

 2. Concept of equilibrium and disequilibrium:

 Equilibrium is a state of balance or a state where there is no change.
 Disequilibrium is a state of imbalance.
Contd.
 3. Static and Dynamic models:
 In Static models , the relations between different variables relate to the same
period in time.
 There is no need to be concerned about the problem of dating.
 Dynamic models trace the changes that occur in the values of the different
variables over time.
 Static models are those where the relationship between the different variables
relates to the same period in time.
 Dynamic models are the models that trace the changes that occur in the
values of the different variables over time.
Contd.
 4. Partial and General Equilibrium:
 A partial equilibrium approach involves the determination of the equilibrium
price and output in each market, ceteris paribus.
 The main problem with a partial equilibrium approach is that it ignores the
interdependence and the linkages between the different markets.
 For example, in analyzing the demand for say commodity X, we assume all
factors other than the price of commodity X including income, tastes, and
price of other commodities to be constant.
 However in reality, the demand for commodity X depends not only on the
price of commodity X but also on the individual’s income, his tastes and the
price of the other commodities, which may be substitutes or complements to
the commodity.
 Contd.

 For example, in an analysis of the maximization of the utility of the consumer we

assume that his income is constant.
 In analysing the demand for say commodity X, we assume all factors, other than
the price of commodity X including income, tastes and price of other
commodities to be constant.
 In the product market, the interaction of the buyers and sellers determines the
equilibrium price and output, ceteris paribus or in other words ignoring the
relationship with the other markets.
 Contd.

 General equilibrium analysis involves a state where all the markets and the
decision-making units in the economy are in a simultaneous equilibrium.
 Hence, it studies the simultaneous equilibria in a group of interrelated markets
emphasizing the interdependence between the different economic units in the
economy.
 While Marshall’s name is associated with partial equilibrium analysis, general
equilibrium analysis is associated with the French economist Leon Walras.
 Statics, Dynamics and Comparative Statics

 Comparative Statics: While static models relate to a study of the equilibrium at a

particular point of time, comparative statics compares two or more such
equilibrium states.
 Comparative statics can be used to analyse, for example, the changes in an
equilibrium price and quantity brought about by the shifts in the demand and/or
supply curves.
 Why a separate study of Macro Economics?

 What is true of parts, is not necessarily true of the whole

 Misleading Conclusions: Macroeconomic Paradoxes
 Paradox of Thrift:
Paradox of thrift was popularized by the renowned economist John Maynard
Keynes. It states that individuals try to save more during an economic recession,
which essentially leads to a fall in aggregate demand and hence in economic
growth.
 Meaning of Macroeconomics

 Greek word “Makros” which means large.

 Studies aggregate behaviour of the economic system
 Determines the level of total economic activity in any nation.
 Origins of circular flow:

 The circular flow analysis of production and consumption by macroeconomic

agents(firms and workers with or without banks) is as almost as old as economics
itself.
 Origins can be traced back to the work of Quesnay (in the 18th century France).
 This approach was popularized for the use of all the money using economies back
then.
 The circular flow of income:

 Real flows which include the flows of the factors of production and the goods
and services between the different sectors.
 Money flows , which include the monetary flows between the different sectors.
The Circular Flow of Income:

 Basic Parameters in an economy: Indicators of economic activity

 Production => National Product => Market value of final goods
and services produced
 Income => National Income => Sum of factor incomes
 Expenditure => National Expenditure => Sum of expenditure
on final goods and services
produced
 Behavior of these parameters is analyzed through Circular flow
of Income
Why is the flow of income called a circular flow?

 Corresponding to each real flow in one direction, there is a money flow in the
opposite direction.
 Receipts and payments across different sectors are always equal.
 Real Flow= Flow of goods and services + Flow of Factor services
 Money Flow= Flow of factor income + Flow of expenditure on good and
services
Circular Flow of income in two sector economy:

 In a two sector economy, there are only two sectors, households and firms.
 There is no government sector and no foreign sector.
 There exists a flow of services from the households to the firms and a
corresponding flow of factor incomes from the firms to the households who own all
the factors of production.
 Factor incomes

Factor services

Households Firms

Flow of goods and services

Expenditure on goods and services

 The firms are engaged in the task of production by combining the different
factors of production; namely, land, labour, capital and entrepreneurship.
 The owners of these factors are the households, which receive wages for labour,
rent on land, interest on the capital and profi t on the entrepreneurship.
 The goods produced by the firms are bought by the households and the payments
made by them for these goods and services are utilized by the fi rms to make the
factor payments.
 Money flow: It consists of following two parts:
 (1) The flow of factor incomes, namely, wages, rent, interest and profits from the firms
to the households.
 (2) The flow of expenditures on the goods and services from the households to the firms.
 Real flows: It consists of following two parts:
 (1) The flow of factor services including land, labour, capital and entrepreneurship from
the households to the fi rms.
 (2) The flow of goods and services from the firms to the households
The Circular Flow of Income in a Two Sector
Economy: Assumptions
There are only 2 sectors: Households and Firms

Households supply factors and firms hire these factor

services.

Households spend their entire income on consumption i.e

no savings

Firms sell all that is produced to the households i.e. no

inventories

There is no Government or foreign trade

Observations:

 Total production of goods and services = Total consumption by households

 Factor payments=factor incomes
 Consumption of households=Income of Firms
 Real flows of production & consumption= Money flows of income and
expenditure of firms and households
 National Income can be calculated as:
 Consumer expenditure on goods and services = Income of the sellers
 The total income from the production of the goods and services which equals
the sum of wages, rent, interest and profits.
 The national income is equal to the national expenditure.
 Thus, the sum total of the factor incomes earned by the households is equal to the
total of the expenditures by the households on the goods and services.
 The total income earned by the households must be equal to the total expenditure
in the economy.
Two sector model with savings and financial
 Consumption Expenditure(Money flow)

Goods & Services (real flow)

Borrowing Financial Saving

Firms Households
System

Factor Services (real flow)

Factor Payments (Money flow)

All income (Y) is not converted into consumption exp. (C) but into C+S,
Y= C+S
S is converted into I, which is expenditure by producers
The model assumes that all the saving is converted into investment
S=I
Y=C+S and S=I, then Y=C+I
Y in terms of C+S shows factor incomes and in terms of C+I shows expenditure
Production=Income generated=Expenditure
Withdrawals(leakages)and Injections:

 The circular flow of income and money would remain constant as long as what is
spent on the goods and services by the households is all distributed by the firms as
factor payments.
 However, reality presents a different picture where there exist withdrawals and
injections of income, which prevent the circular flow of income and money from
remaining constant.
 Withdrawal (or leakage) is income, which is generated in the production of the
national output and which does not become a part of the circular flow of income.
 There are three types of withdrawals: saving, taxes and imports.
 In reality every individual in an economy saves.
 S =Y-C where, S =saving, Y =income, C =consumption
Contd.
 Thus, saving is a withdrawal of income and leads to a decrease in the income level.
 The savings by the firms also represent a withdrawal and lead to a decrease in the
income level.
 Similarly, taxes and imports represent withdrawals and hence lead to a decrease in
the circular flow of income.
 Injection is an amount of money, which is spent by the different sectors in the
economy and which is in addition to their incomes generated in the circular flow of
income.
 There are following three types of injections, which are as follows:
 (1) Investment: expenditure on plant and equipment, machinery and inventories.
 (2) Government expenditure
 (3) Exports
 Contd.

 As far as the household sector is concerned, withdrawals take the form of saving,
personal income tax, sales tax, and imports whereas injections include
government expenditures.
 As far as the firms are concerned, withdrawals take the form of corporation tax,
business taxes and business savings whereas injections include government
expenditures, investment expenditures and exports of goods and services.
 Contd.

 In equilibrium, the leakages are equal to the injections and the size of the circular
flow remains the same.
 If injections are greater than the leakages, the circular flow will grow and there is
prosperity in the economy.
 If on the other hand injections are less than leakages, the circular flow will
become smaller in size and there is recession in the economy.
THE CIRCULAR FLOW IN A THREE SECTOR
ECONOMY
 We now introduce a third sector, the government sector.
 The inclusion of the government sector makes the model more realistic as the government
plays an important role in the economy.
 The government raises its revenue from many sources. However, its main source of revenue
is taxes.
 Taxes levied on the household sector: direct taxes like the income tax or indirect taxes like the sales tax
and excise duties on the consumer goods.
 Taxes levied on the firms: These can be direct taxes like the corporate income tax or indirect taxes like the
sales tax and excise duties.
 T=TH + TF (Taxes levied on households and firms respectively)
 Government expenditure: It has to incur expenditure on many heads.
 Expenditure on administration, justice, defense, development, social welfare activities, subsidies and so on.
contd.

a) Payments made to the household sector for the services rendered by them;
for example, for those working in the armed forces, civil services and others.
 (b) Payments made to the firms for the goods and services bought from them.
 (c) Subsidies given to the firms to encourage production in certain areas and
in certain sectors in the economy.
 (d) Payments made for social security and welfare; these include pensions,
unemployment compensations and other transfer payments.
 G= GH + GF + GS + GW (Payments to household, firms, subsidies,
Welfare and Social security respectively).
 Contd.

 G =total government expenditure.

 GH= payments made to the household sector for the services rendered by them
GF= payments made to the firms for the goods and services bought from them.
 Gs = government subsidies to the firms.
 GT= government payments for social security and welfare.
Contd.

 The government may follow a balanced, deficit or a surplus budget.

 The classical economists are in favour of a balanced budget where the
government expenditure is always equal to the government revenue or where
G =T. (T=Taxes)
 Hence, the amount of income withdrawn from the circular flow as taxes re-
enters the flow as government expenditure.
 The government often follows a deficit budget.
 Often, the government expenditure is much greater than their revenue or
G > T.
 Contd.

 The difference is financed from loans from the capital market.

 Such a budget implies net injections and thus an expansion in the circular flow of
income.
 In a surplus budget, the government expenditure is less than their revenue or G <
T.
 Such a budget implies net withdrawals and thus a contraction in the circular flow
of income.
Important Points:

 (1) A part of the flows between the households and the firms now gets
diverted to the government sector;
 (2) A part of the household income goes to the government sector in the form
of taxes;
 (3) A part of the firms’ earnings go to the government sector in the form of
taxes;
 (4) A part of the tax revenue is spent by the government as government
expenditure on services and transfer payments to the household sector;
(5) A part of the tax revenue is spent by the government as government
expenditure on goods and subsidies to the firms.
 Contd.

 In addition, a flow of income between the government sector and the capital market may
also exist.
 (1) In case the government follows a deficit budget and the government expenditure is
greater than the revenue or G > T, the difference is financed from loans from the capital
market.
 Hence, money will flow from the capital market to the government sector.
 (2) In case the government follows a surplus budget and the government expenditure is
less than the revenue or G < T, money will flow to the capital market from the
government sector.
 However, in today’s world this seems to be a rare occurrence.
THE CIRCULAR FLOW OF INCOME IN A FOUR SECTOR ECONOMY

 A four sector economy where besides the household, firms and the
government, the fourth sector is the foreign sector.
 When a country imports goods and services, the expenditure incurred by the
residents of the domestic country leads to an increase in the income of the
factors of production of the country which is exporting the goods and services
(and not the domestic country).
 Hence, imports lead to an outflow of income and thus to a decrease in the
circular flow of income.
 Contd.

 When a country exports goods and services, the expenditure incurred by the
residents of the foreign country leads to an increase in the income of the factors
of production in the domestic country which is exporting the goods and services.
 Hence, exports lead to an inflow of income and thus to an increase in the circular
flow of income.
Contd.
 Two Situations are possible:
 The exports of a country are less than its imports or X < M: Hence, there is a
foreign trade deficit
 equal to (M -X) or an unfavourable balance of trade.
 As imports are greater than exports, or withdrawals are greater than
injections there will be a decrease in the circular flow of income.
 The exports of a country are greater than its imports or X > M: Hence, there
is a foreign trade surplus equal to (X -M) or a favourable balance of trade.
 As exports are greater than imports, or in other words, injections are greater
than withdrawals there will be an increase in the circular flow of income.