SESSION 1 - 3

1. INTRODUCTION TO
MACROECONOMIC
CONCEPTS
2. KEYNESIAN CROSS
3. ISLM FRAMEWORK
Central Problems of Macroeconomics?

Growth (Changes in the growth of Real GDP)

Business Cycles

Unemployment

Inflation
What is Macroeconomics?

Microeconomics is the study of individual behaviour

Theory of Firm, Theory of Price Determination of a
commodity

Macroeconomics is the study of aggregates

National Income, Output, Employment and General
Price Level
Basic Concepts in Macroeconomics

Output / Incomes (Gross Domestic Product, National
Income)

Unemployment

Inflation
Gross Domestic Product

The total market value of all final goods and services
produced within a country in a given period of time.

Does not include goods that do not enter the market place

Does not include the Black Economy

Ignores value of leisure, environment

Related Concepts

Depreciation (Gross vs. Net)

Net Factor Income from Abroad (Domestic vs. National)

Net Indirect Taxes (Market Price vs. Factor Cost)

National Income (NNP at FC)
Goods & Factor Markets: Circular Flow
MARKETS
Revenue FOR Spending
GOODS AND SERVICES
Goods •Firms sell Goods and
and services •Households buy services
sold bought
FIRMS HOUSEHOLDS
•Produce and sell •Buy and consume
goods and services goods and services
•Hire and use factors •Own and sell factors
of production of production
Factors of MARKETS Labor, land,
production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, •Households sell Income
and profit •Firms buy
= Flow of inputs
and outputs
= Flow of dollars
Copyright © 2004 South-Western
Components of GDP

Consumption

Spending on goods & services by individuals

Doesn’t include spending on housing

Investment

Business Fixed Investment

Residential Investment

Addition to Inventories

Government Expenditure

Spending by local, state and federal govt.

Does not include transfer payments (WHY?)

Net Exports
Further concepts on GDP

Real vs. Nominal GDP

Nominal GDP values the production of goods and services at
current prices.

Real GDP values the production of goods and services at constant
prices.

Nominal GDP can be adjusted to Read GDP by using the GDP
deflator (Ratio of Nominal GDP to Real GDP)

What is Growth?

Factors that increase productivity

Physical Capital

Human Capital

Natural Resources

Technological Knowledge
Question for Discussion

Is GDP a good measure of well being?

GDP = Gross Deceptive Product?

Is
Growth equal to Development
Inflation

Percentage change in the price level from the previous
period

What is the Price Level?

Consumer Price Index

Wholesale Price Index

How are the CPI and the WPI prepared in India? Which is
better?

Types of Inflation

Demand Pull

Cost Push

A rise in CPI in commensurate with a fall in the rate of
Inflation!
Inflation

Real vs. Nominal Interest Rates

The nominal interest rate is the interest rate usually
reported and not corrected for inflation. It is the
interest rate that a bank pays.

The real interest rate is the nominal interest rate that is
corrected for the effects of inflation. It is the difference
between the nominal interest rate and inflation rate

What are the current levels of interest rates in India?
Unemployment

Willingness to work but unable to find a job at the
prevailing wage rate; percentage of labour force that
is unemployed

Natural Rate of Unemployment: The amount of
unemployment that the economy normally experiences.
Does not go away even in the long run

Frictional Unemployment

Cyclical unemployment refers to the year-to-year
fluctuations in unemployment around its natural rate. It is
associated with short-term ups and downs of the
business cycle.
Business Cycles

Upward or Downward movement of economic activity
that occurs around a growth trend

All economies go through a business cycle

Phases of Business Cycles

Peak (top of the business cycle)

Boom (very high peak)

Downturn (falling from the peak)

Recession (decline in output that stays for at least 2
consecutive quarters)

Depression (large recession)

Trough (Bottom of recession or depression)

Upturn or Expansion (coming out of the trough!!)
Phases of a Business Cycle
Classical vs. Keynesians

Classical (Supply creates its own demand)

Demand for labour depends on real wage rate, hence
unemployment can be reduced by reducing the wage
rates

Keynesians (Demand will create supply)

To come out of depression, increase wage rates =>
purchasing power will increase and people will
demand more goods => to meet the increasing
demand, firms will hire more labour
DETERMINATION OF INCOME
AND EMPLOYMENT
 Introduction

One of the central questions in macroeconomics is why output fluctuates
around its potential level

In business cycle booms and recessions, output rises and falls relative
to the trend of potential output

First theory of these fluctuations in real output relative to trend

Mutual interaction between output and spending: spending determines
output and income, but output and income also determine spending

The Keynesian model of income determination develops the theory of AD

Assume that prices do not change at all and that firms are willing to
sell any amount of output at the given level of prices → AS curve is
flat
AD and Equilibrium Output

AD is the total amount of goods demanded in the
economy:
AD = C + I + G + NX

Output is at its equilibrium level when the quantity of
output produced is equal to the quantity demanded, or
Y = AD = C + I + G + NX

When AD is not equal to output there is unplanned
inventory investment or disinvestment, where IU is
unplanned additions to inventory
IU = Y − AD

If IU > 0, firms cut back on production until output and AD
are again in equilibrium
The Consumption Function

Consumption is the largest component of AD

Consumption is not constant, but increases with income → the
relationship between between consumption and income is
described by the consumption function

If C is consumption and Y is income, the consumption function
is
C = C + cY where C > 0 and 0 <c <1

The intercept of equation is the level of consumption when
income is zero → this is greater than zero since there is a
subsistence level of consumption

The slope of equation is known as the marginal propensity
to consume (MPC) → the increase in consumption per unit
increase in income
The Consumption Function
[Insert Figure 9-1 here]
Equilibrium Income and Output

Equilibrium occurs where
Y=AD, which is illustrated by
the 45° line in Figure

The arrows in Figure show how
the economy reaches
equilibrium

At any level of output below Y0,
firms’ inventories decline, and
they increase production

At any level of output above Y0,
firms’ inventories increase, and
they decrease production
Process continues until reach Y0
9-29
The Formula for Equilibrium Output
 Ex. If the MPC = 0.9, then 1/(1-
Y − cY = A c) = 10 → an increase in
government spending by $1 billion
results in an increase in output by
Y (1 − c) = A $10 billion
 Recipients of increased
government spending increase
1 their own spending, the recipients
Y0 = A of that spending increase their
(1 − c) spending and so on
 MULTIPLIER IMPACT!!
Consumption and Savings

Income is either spent or saved → a theory that
explains consumption is equivalently explaining the
behavior of saving

Savings function

Saving is an increasing function of the level of
income because the marginal propensity to save
(MPS) = 1-c is positive
 Savings increases as income rises
The Government Sector

The government affects the level of equilibrium
output in two ways:
1. Government expenditures (component of AD)
2. Taxes and transfers

Fiscal policy is the policy of the government with
regards to G, TR, and TA

Assume G and TR are constant, and that there is a
proportional income tax (t)

The consumption function becomes:
C = C + c(Y + TR − tY )
= C + cTR + c(1 − t )Y
 The Government Sector
The presence of the government sector flattens the
AD curve and reduces the multiplier to
Y = A + c (1 − t )Y
Y − c (1 − t )Y = A
Y [1 − c (1 − t ) ] = A
A
Y0 =
1 − c (1 − t )
1
Multiplier
(1 − c(1 − t ))
The Budget

The budget surplus is defined
as:
BS ≡ tY − G − TR
9-34
Numericals

Suppose total income increases from Rs. 1000
crores to Rs. 2000 crores and the total consumption
increases from Rs. 800 crores to Rs. 1400 crores
what is the marginal propensity to consume?

Suppose that the marginal propensity to consume is
0.8, and investment spending increases by $100
billion. What is the increase in aggregate demand?
Numericals

The consumption function for country X is given as C
= 50 +0.8Y. Find out the equilibrium level of
aggregate output if the autonomous investment
equals $100, Government Expenditure equals $
200. The tax rate for the economy is 25%.

Find out the Budget surplus if transfers equal $ 100.
 SESSION 4
SAVINGS AND INVESTMENT
INTRODUCTION TO MONEY
MARKETS
What are Interest Rates?

Time value of Money

A rupee spent today is worth more than a rupee spent
tomorrow

Uncertainty about future

Tradeoffs between consumption and saving

The ISLM Model

Maintains the previous discussion adding the interest
rate dimension

Investments are not autonomous but depend on the level
of interest rates
 The IS Curve

The IS curve shows combinations of interest rates
and levels of output such that planned spending equals income

Derived in two steps:
1. Link between interest rates and investment
2. Link between investment demand and AD

Investment is no longer treated as exogenous, but dependent upon
interest rates (endogenous)

Investment demand is lower the higher are interest rates
 Interest rates are the cost of borrowing money
 Increased interest rates raise the price to firms of borrowing
for capital equipment → reduce the quantity of investment
demand
Investment and the Interest Rate

The investment spending
function can be specified as:
I = I − bi where b > 0

i = rate of interest

b = the responsiveness of
investment spending to the interest
rate

I = autonomous investment
spending

Negative slope reflects
assumption that a reduction in i
increases the quantity of I
10-40
The Interest Rate and AD: The IS Curve
All points on the IS curve
represent combinations of i and
income at which the goods
market clears → goods market
equilibrium schedule
10-41
Demand for Money

There are 3 motives for which money is demanded

Transaction
 To carry out day to day transactions
 Depends positively on the Level of Income
 Not impacted by the interest rate (Keynes)

Precautionary
 Money demanded by the public to meet unexpected delay in
receiving payment or unanticipated increase in expenditure
 Usually clubbed with the transaction demand

Speculative
 Inverse relationship between speculative demand and interest rate
Speculative demand for Money

The Bond Market

Assumption: the only alternative to holding money is the bond
market

If you expect bond prices to increase, you buy

If you expect bond prices to decrease, you sell

Bond is an instrument on which the government is committed to
pay us a “fixed interest” in absolute terms, not relative (Discount
Rate)

Price of the bond = Return fixed on the bond / Market rate
of interest

Inverse relationship between interest rate and price of bond

As interest rate decrease, bond price increase, demand for
bonds decrease, demand for money increases!
Money Supply

Money supply is a stock concept whereas GDP is a flow concept

Velocity of money is the number of times Money exchanges hand. It is
calculated as the ratio between GDP and money supply

MV = PY

What are the measures of money supply

M1= C + DD

M3 = C + DD + TD

M2 = M1 + Post Office Savings Deposit

M4 = M3 + Total Post Office Deposits

Which of the above is the most liquid?

What are Time and Demand Deposits

Savings Account, Current Account and Fixed Deposit Account
Equilibrium Level of Interest Rates

Money Demand = Money
Supply

Money Supply is Constant

If i>i*, there is excess supply
of money; excess money
spent on buying bonds; as
demand for bonds increases
price also increases; interest
rates decline

If i<i*, there is excess
demand for money; People
sell bonds; price decreases;
interest rates increases
The Money Market and the LM Curve

The LM curve shows combinations of interest rates
and levels of output such that money demand
equals money supply → equilibrium in the money
market

The LM curve is derived in two steps:
1. Explain why money demand depends on interest rates and
income
2. Equate money demand with money supply, and find
combinations of income and interest rates that maintain
equilibrium in the money market
Equilibrium and the Goods and Money
Market
[Insert Figure 10-11 here]

The IS and LM schedules
summarize the conditions that
have to be satisfied for the
goods and money markets to
the in equilibrium

How are they brought into
simultaneous equilibrium?

Assumptions:

Price level is constant

Firms willing to supply whatever
amount of output is demanded at
that price level
10-47
Inconsistency with the Keynesian Model

When you determine equilibrium output from the
goods market, you need to know the interest rate
from the money market

When you determine equilibrium interest rate in the
money market, you need to know income from the
goods market

Hence, we use simultaneous determination of income
and interest rates from the ISLM framework
Fiscal and Monetary Policy

Expansionary Fiscal Policy

Moves the IS curve to the right

Output increases, interest rate increases

Contractionary Fiscal Policy

Moves the IS curve to the left

Output decreases, interest rate decreases

Expansionary Monetary Policy

Moves the LM curve to the right

Output increases, interest rate decreases

Contractionary Monetary Policy

Moves the LM curve to the left

Output decreases, interest rate increases
Instruments of Fiscal Policy

Increase in Government
Expenditure

Increase in income is less
than the Keynesian
multiplier

Due to fiscal policy
expansion, interest rates
increase and private
investment reduces

Hence there is
CROWDING OUT

In this transmission
mechanism, adjustments
happen along the LM curve
Instruments of Monetary Policy

Reserve Ratios

Cash reserve Ratio

Statutory Liquidity Ratio

Policy Rates

Repo Rate

Reverse Repo Rate

Bank Rate

Prime Lending Rate

Savings Deposit Rates

Fixed Deposit Rates
Reserve Ratios

Proportion of the deposits that the commercial bank
has to keep with the RBI is the Cash Reserve Ratio

Inverse relationship between CRR and Money Supply

Proportion of deposits that the commercial bank has
to keep in government securities is the Statutory
Liquidity Ratio

Inverse relationship between SLR and Money Supply
Policy Rates

The rate at which Commercial Banks borrow from
the RBI to meet its long term liquidity needs is the
Bank Rate

The rate at which Commercial banks borrow from
the RBI to meet its short term liquidity needs in the
Repo Rate

The rate at which Commercial banks lend to the RBI
for short term is the Reverse Repo Rate

Inverse Relationship between Policy Rates and
Money Supply