Introduction to Macro Economics

Historical Evolution of Macro Economics Adam Smiths Absolute Advantage Theory, David Records Comparative Advantage Theory, Great Depression I 1929 (Over production, unemployment etc) World War II

Diversion of research interests from science to social science. (Lawrence Clain, John Nash, Simon Kuznets, Samuelson, Joan Rabinson, Charles Chamberlin etc)
J .M. Keynes work: The General Theory of Employment, Interest and Money published in the year 1936 laid foundation for Macro Economics.

Definitions of Macro Economics Macro economics is concerned with the behavior of the economy as a whole and analyzes the causes of major problems such as unemployment, inflation, low wages, low economic growth and increasing trade deficits. It is a study of economic aggregates such as total employment, national product and national income, the general price level of the economy. It deals with both short term fluctuations business cycles and long term changes economic growth.

Macroeconomic analysis attempts to study and explain why macroeconomic problems exist and how they can be tackled.
Greek prefixes macro and micro were first introduced in economics by Prof. Ragnar Frisch in 1933.

Micro and Macro Economics

Micro Term derived from the Greek word mikros which means small. - It deals with small individual units, of the economy such as individual consuming households, individual firms, individual industries and various product and factor markets. Microscopic study of the working of the economy. - Discuss how the various decisionmaking individual units of the economy such as thousands of consuming households, firms, workers in the economy do their economic activities and reach their equilibrium states. Discuss equilibrium of innumerable individual units of the economy and their inter-relationship with each other. Macro Economics Derived from the Greek word macros meaning large and therefore it is concerned with the large or total economic activity. Explains the behaviour of whole economic system in totality. Aggregative economics - Studies the behaviour of the large aggregates such as total employment, national product or income, the general price level of the economy.

It explains the determination of the level of national income and employment, and general level of prices.

General Macro economic goals:

high level of output (GDP), full employment, price stability, sustainable balance of payments and rapid economic growth.

GROSS DOMESTIC PRODUCT (GDP)

It is the market value of all goods and services produced by factors of production located within the boundaries of a country, during a specified period of time usually one year.

Nominal gdp measures domestic output value in current market prices.

Real gdp adjusts the nominal gdp for price changes (inflation) and so serves as a good measure of comparison between time periods and between countries.

GDP is the best indicator of the economic performance of a country both in the short run and long run.

FULL EMPLOYMENT It is considered as the primary and well accepted goal of macroeconomic policy of the government which will help alleviate poverty. The unemployment rate is defined as the percentage of labor force that is unemployed in a country. In the recession phase of a business cycle unemployment rate increases as demand for labor falls while in the boom phase unemployment rate decreases as demand for labor increases.

PRICE STABILITY

Prices affect purchasing power of money incomes and so standard of living of people. Inflation is a continuous rise in the general price level seen in the upward rate of change in the price index. An extreme form of inflation is called hyper inflation. Inflation in general reduces the purchasing power of money. Deflation also called negative inflation rate is continuous decrease in the general price level.

In terms of economic stability neither high inflation nor high deflation is advisable. Rapid price changes disturbs economic decisions of companies because it upsets cost calculation and of individuals because it upsets real income. So macroeconomic policy aims for steady or gentle rise in prices rather than shock fluctuations of very high inflation or very high deflation.

SUSTAINABLE BALANCE OF PAYMENT

Balance of payment is a systematic record of all economic transactions between a country and the rest of the world.
Balance of trade which is a part of the balance of payment is an important indicator of the status of a countrys foreign trade.

Balance of trade is a systematic record of merchandise exports and imports between a country and the rest of the world.
Net exports, a measure of the BOT, is the difference between the above two variables. It is positive net exports if merchandise exports of a country exceed its imports and negative net exports if its merchandise imports exceeds it exports.

ECONOMIC GROWTH
Economic growth usually refers to: an increase in the production possibility curve or schedule and growth in real GDP or in real per capita output.

Per capital GDP growth is measured by: [1 + g] / [1+ p] 1

where, g = % growth of GDP, p = % growth of population.

INSTRUMENTS OF MACROECONOMIC POLICY

Governments use macroeconomic policies which influence economic activity so as to achieve economic objectives.
OBJECTIVES High output level INSTRUMENTS / TOOLS Monetary policy

Low unemployment rate

Stable price level

Fiscal policy
Exchange rate monetary policy policy &

Maintenance payments

of

balance

of Prices and incomes policies

Employment policy

Steady economic growth

FISCAL POLICY
Fiscal policy refers to policy regarding expenditure and revenue of the public authority be it the local or state or national government.

Government consists of its purchases (spending on goods, services, infrastructure construction and maintenance, salaries of public servants etc) and transfer payments (financial assistance to some select groups).

Government spending influences private spending allocations in the economy and so the GDP level. Government revenue, especially tax revenue, affects the economy in two ways: impacts private disposable income and so private purchasing power as well as saving; the first impact affects overall output and investment; also affects prices of goods, services and factors of production.

MONETARY POLICY All modern economies are monetized using money as a meaning of exchange and a store of value i.e. liquid financial asset. A economys monetary system consists of institutions that create financial assets and its leader is the central bank which formulates as well as implements the monetary policy that influences total quantity of money, interest rates and the volume of credit impacting on real macro economic variables like GDP, capital formation, employment and price level.

INTERNATIONAL TRADE POLICY Trade policy consists of trade regulations, tariff or non-tariff based, that restricts or promotes a countrys imports and exports. Many countries use trade policy as a strategic tool to increase economic growth e.g. Far East Asian economies.

EXCHANGE RATE POLICY Foreign exchange management is a part of monetary policy that has an impact on trade policy because its most important component is management of the countrys exchange rate. Exchange rate: amount of domestic currency to be paid for a unit of a foreign currency. There are two popular exchange rate systems: Fixed exchange rate: fixed by the government and Floating exchange rate: freely determined by demand for and supply of currencies with intervention by the monetary authority or the government.

PRICES AND INCOME POLICY Government sets the prices of some goods and services as well as determines wages.

Used to influence the economy inflation etc.

market

EMPLOYMENT POLICY

Policy and programmes with the objective of generating employment opportunities.

Done through government projects that are deliberately labor intensive and also through free training facilities of unskilled labor etc.

BASIC CONCEPTS OF MACROECONOMICS STOCKS AND FLOWS A stock variable is measured at a specific point of time and a flow variable is measured over a specified period of time.

STOCK VARIABLES Money supply Consumer price index Unemployment level Foreign exchange reserves

FLOW VARIABLES GDP Inflation Exports & imports Consumption & investment

EQUILIBRIUM AND DISEQUILIBRIUM Economic equilibrium is a state of balance between opposing forces or actions wherein the action of the variables is repetitive such that the continuous change does not established position.

Disequilibrium is the absence of the above state of equilibrium.

STATICS AND DYNAMICS

Economic models deal with stock and flow variables which may be either in equilibrium or disequilibrium at a point of time.
Models which do not consider explicitly the behavior of variables from one time period to another, thus not having a time dimension and consequently indicating only the direction of change in economic variables but not their process of change are called Static Models. Models which consider the movement of variables over different time periods thus relating what happens in current time to preceding as well as future time periods and consequently able to describe movement of variables from one disequilibrium position to another, until equilibrium is ultimately reached are called Dynamic Models.

National income accounting

National income accounting a set of rules and definitions for measuring economic activity in the aggregate economy i.e., in the economy as a whole. National income accounting is a way of measuring total, or aggregate production

What Is National Income?

It is the money value of all the final goods and services produced by a country during the period of one year Since goods are measured in different physical quantities (for eg. Cloth in metres, etc), the value of the goods and services produced is measured in money and summed up to give nothing but the value of national income or national product.

MEASURING NATIONAL INCOME

Three approaches: 1. Product approach. 2. Income approach. 3. Expenditure approach.

PRODUCT APPROACH
Calculate total value of final output of a country.
Aggregation of the product of goods or services & their respective prices.

NI = P1Q1 + P2Q2 + P3Q3 + ---+PnQn.

INCOME APPROACH
All factors contribute to final output. Value of final output equals total income of production factors. PiQi = Wi + Ri + Ii + Pi

EXPENDITURE APPROACH
Aggregate of the flow of total expenditures on final goods and services. Spending entities: government. households, business firms &

National income equal to sum of expenditures of all three sectors. Ideal result of all three approaches: same.

DOMESTIC vs. NATIONAL CONCEPTS

NATIONAL: normal residents participating in production process irrespective of domestic or foreign residence. Considers origin of factors. DOMESTIC: within the domestic territory i.e. within geographical boundaries of a country.

GROSS vs. NET CONCEPTS

GROSS: no allowance for capital consumption i.e. Depreciation. NET: make provision for capital consumption i.e. Depreciation.

MARKET PRICES vs. FACTOR COST

MARKET PRICE: includes indirect taxes & excludes subsidies. FACTOR COST: opposite of the above.

GDP at MARKET PRICES

Most comprehensive measure. Deduct net exports from total final expenditure.
C + I + G + (X M)

GDP at factor cost

GDP at factor cost = GDP at market prices + Subsidies Indirect taxes.

GNP at Factor Cost

Total income received by residents as factors anywhere in the world. Add wages, interests, profits and dividends received by citizens and subtract the same items received by foreigners on assets they own in India.

GNP at factor cost = GDP at factor cost +/- Net factor income from abroad.

NNP at factor cost

NNP at factor cost = GNP at factor cost Depreciation.

PERSONAL INOCME
PERSONAL INCOME = NNP at factor cost Corporate taxes Undistributed profits + Transfer Payments

DISPOSABLE INCOME

DISPOSABLE INCOME = Personal Income Personal Taxes.

Important facts
Distinguish between closed economy and open economy.

A closed economy has no economic relations with the rest of the world.
This type of economy is not affected by the economic activities of other countries. It is an imaginary economy. It is not found in the world. An open economy is one which has economic relations with the rest of the world. Mostly all the economies in the world are of this type. It is affected by the activities of the other countries

DIFFICULTIES IN NATIONAL INCOME MEASUREMENT

Difficulty of defining nation in the terminology national income. There are a number of goods and services which are difficult to be assessed in terms of money.

The failure to distinguish properly between a final and an intermediate product.

Income earned through illegal activities are not included in national income. Transfer payments- these earnings are a part of individual income and also government expenditure.

DIFFICULTIES IN NATIONAL INCOME MEASUREMENT

Capital gains or loss to property owners excluded from GNP because they do not result from current economic activities. All inventory changes at original cost not replacement costs included in GNP measure.

Depreciation valuation adjustment is full of statistical difficulties.

With price increase, monetary NI increases though production may have gone down & with price fall monetary NI falls though production may have gone up. Monetary NI an underestimation of real NI. Public services cannot be estimated correctly.

DIFFICULTIES IN DEVELOPING COUNTRIES

Large non-monetized sector. Lack of occupational specialization. Several productive activities do not enter market transactions. Many people do not keep accounts. Adequate and correct production and cost data are not

available.