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NASEER SHAHZADAeconomypk@yahoo.com

Introduction to Macroeconomics

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Contents• National Income Accounting

• Aggregate Demand and Aggregate Supply

• Macroeconomic Equilibrium

• Money and Banking

• Integration of Goods and Money Markets (IS-LM)

• Fiscal and Monetary Policies

• Business Cycles

• Inflation and Unemployment

• International Trade and Balance of Payments

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Why to study Macroeconomics?• To understand the functioning of an economy

– What causes fluctuations in demand?

– What leads to instability in interest rates, prices (inflation rates), exchange rates?

• To understand the direction of govt. policies

• To take a decision on timing of fresh investments, takeovers, enter new markets, etc.

• To get best return on investment

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Macroeconomic – An Introduction• Macroeconomics – study of the behavior and

performance of the economy as a whole

• Study of factors or forces determining the level and growth of macroeconomic aggregates

• Macroeconomic aggregates (macroeconomic variables) – output, income, employment, price level, balance of payment positions, etc.

• Aggregate behavior refers to the behavior of all households and firms together.

Concepts in Macroeconomic Analysis

Stock and Flow Variables• Stock: quantity of a variable at a point in time

Eg: Capital stock, money supply, unemployment level, foreign exchange reserve, etc.

• Flow: quantity expressed for a period of time

Eg: GDP, inflation, exports, consumption, etc.

Concepts in Macroeconomic AnalysisAggregate Demand and Aggregate Supply• Aggregate Demand: sum of demands for all

consumer goods and services and for capital goods

Sum of consumption, investment, government expenditure and net export.

• Aggregate Supply: sum of the supplies of all consumer goods and services and of capital goods

The amount of output the economy can produce given the resources and technology available

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The Roots of Macroeconomics• The Great Depression was a period of

severe economic contraction and high unemployment that began in 1929 and continued throughout the 1930s.

• A recession is a period during which aggregate output declines. Two consecutive quarters of decrease in output signal a recession.

• A prolonged and deep recession becomes a depression.

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The Roots of Macroeconomics• Classical economists applied microeconomic models, or

“market clearing” models, to economy-wide problems

• Main argument: ‘Supply creates its own demand’- Say’s law

• No intervention by the government (Laissez faire). Economy should be left to market forces (‘invisible hand’)

• The failure of classical models to explain the prolonged existence of high unemployment during the Great Depression led to the development of macroeconomics

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The Roots of Macroeconomics• In 1936, John Maynard Keynes published The General

Theory of Employment, Interest, and Money.

• Keynes arguments:

– The level of output and employment in an economy is determined by the aggregate demand (AD)

– Governments could intervene in the economy and affect the level of output and employment

• Two important objectives of macroeconomic policies:

(a) Sustained growth in GDP, and (b) Price stability

Functions of an Economy

• An economy is a complex arrangements of many different buyers and sellers – households, businesses, government, and the rest of the world – and of their interactions with each other

• An economy employs various resources to produce a variety of goods and services for domestic and world consumption, and provides income for the resources

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The Components of the Macro Economy

• An economy can be pictured as a schematic of closely linked sectors – households, businesses, financial institutions, governments, and foreigners

• A change in one sector’s transaction with another sector will trigger changes in the entire schematic

• The circular flow of income and output diagram shows the income received and payments made by each sector of the economy

Two-sectors Circular Flow

Households Business/ Firms

Product Market

Factor Market

Wages, rent, interest, profit

Spending Revenue

Labor, land, capital,

entrepreneurship

Inputs for production

Goods & Services sold

Goods & Services bought

Income

Financial Sector

Saving Investment

Three-sectors Circular Flow

Households Business/ Firms

Product Market

Factor Market Wages, rent, interest, profit

Consumption Spending (C)

Financial Market Saving = Investment (S=I)

Government

Govt. expenditure (G)

Direct taxes Direct/Indirect taxes

Govt. expenditure (G)

Four-sectors Circular Flow

HouseholdsBusiness/

Firms

Wages, rent, interest, profit

Consumption Spending (C)

Saving = Investment (S=I)

Government

Govt. expenditure (G)

Direct taxes Direct/Indirect taxes

Govt. expenditure (G)

ExternalSector

Export of services Payments for imports

Receipts from exportsRemittances

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The Three Market Arenas• Households, firms, the government, and the rest of the

world all interact in the goods-and-services, labor, and money markets.

Who create demand and supply in these markets?

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Leakages and Injections• Leakage/Withdrawal: is the amount that is set aside by

the households, firms, and governments and is not spent on the domestically produced goods and services over a period of time

• They reduce the size of the circular flow

Ex: savings, taxes, imports

• Injection/Addition: is the amount spent by households and firms in addition to their regular incomes and receipts

• Injections increase the size of the circular flow

Ex: investments, govt. expenditures, exports

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National Income – Concepts and Measurement

National Income Accounting

Why National Income Accounting? Provides common standards of measurement of

the size of an economy

Helps to evaluate the economic condition of a country and to compare conditions across time and across countries

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National Income – ConceptsDifferent concepts of NI - The Criteria

(i) Items included in or excluded from the NI concept

(ii) Method of estimating NI

Gross Domestic Product (GDP)

• The sum of market value of all final goods and services produced in a country during a specified period of time, generally one year.

• Also called GDP at market prices (GDPMP)

iiPQGDP

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National Income – Concepts• Market values of final goods and services are taken

• Includes net indirect taxes

• Considers only final goods and services• Intermediate goods are excluded to avoid the problem of

double-counting

• Considers output produced in a year • The year of production, not the year of sale

• Inventory as such is not included, but changes in inventory* is considered

*Changes in inventory count output that is produced but not sold in a given year

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National Income – ConceptsGDP at factor cost (GDPFC) is the sum of all factor

payments (wages, interest, rent, profits and depreciation)

GDPFC= GDPMP – Net indirect taxes

(Net indirect taxes = Indirect taxes – Subsidies)

Gross National Product (GNP)

The concept of GNP is similar to GDP, but with a significant difference.

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GDP measures the total value of goods and services that are produced within a country’s geographical borders

• Example: An Indian MNC in China will actually contribute to Chinese GDP

GNP measures the total value of all final goods and services that a country’s citizens produce regardless of where they produce them

• Example: Profits of Indian MNCs earn in overseas market is included in India’s GNPGNP = GDP + NFIA (Net Factor Income from Abroad)(NFIA=income earned by residents abroad – income earned by non-residents from our country)

GDP vs. GNP

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Net National Product (NNP)• GNP included final consumer goods + capital goods• Depreciation: part of capital goods that is used up

or consumed in the process of production• Usually covered under Gross Investment

(Gross Investment = Net Investment + Replacement Investment/Depreciation)

• NNP = GNP – Depreciation• NNPFC = NI (the actual measure of National Income)

• Per Capita Income = (NNPFC = NI ) / Total Population

National Income – Concepts

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Personal Income (PI)• The sum of all kinds of income received by the individuals

from all sources of income• The share of NI actually received by the HH sector

Personal Income (PI) = National Income (NI) Minus – Income earned but not received (undistributed corporate profits,

social security contributions by the HHs (PF, pension funds), etc.) Plus + Income received but not earned now (transfer payments by

business and govt. to HHs, dividend income, etc.)

Disposable Personal Income (DPI): the income at the disposal of a person

DPI = PI – Direct taxes

National Income – Concepts

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Nominal and Real GNP

• GNP is estimated at current and constant prices

• Nominal GNP: market value of all final goods and services measured in current year prices

• Real GNP: market value of all final goods and services measured in the price of a base year (constant prices)

• Why do we estimate GNP at constant prices?

• How to convert the nominal (current) values into real (constant) values?

National Income – Concepts

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GNP Deflator

• An index of price changes for goods and services included in GNP

• Used to deflate the nominal GNP to eliminate the price effect to find real GNP for any year

Real GNP = Nominal GNP / GNP Deflator

GNP Deflator = Nominal GNP / Real GNP x 100

National Income – Concepts

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National Income AccountingGDP (Gross Domestic Product)

(Rs. crore)

2006-07 2007-08 2008-09 2009-10 2010-11

At current prices 4283979 4947857 5582623PE 6550271QE 7877947AE

Growth rate 15.6 15.5 12.0 17.3 20.3

At 2004-05 prices 3564627 3893457 4162509PE 4493743QE 4879232AE

Growth rate 9.7 9.2 6.8 8.0 8.6

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National Income Measurement

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Measurement of NI - Methods• A complex process

• Product flows (Real flows) and Money flows (factor payments and payments for goods and services)

• Three approaches of measuring NI:

– Product Approach

– Factor Income Approach

– Expenditure Approach

Measurement of NI - MethodsThe Product Method• Also known as Output Method or Value Added

Method

• Either by valuing all the final goods and services during a year OR

• By aggregating the values imparted (value added) to the intermediate products at each stage of production (to avoid Double Counting)

(Value added is the difference between the value of output and the value of the intermediate goods used in the production of that output)

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Measurement of NI - MethodsMethod

• Classification of output under various categories

(15 sub-categories are currently used in India)

• Computation of gross value of output of each category by multiplying the output of each category by their respective market prices and adding them together

• OR by summing up the value added at each stage of production

• This gives GDP at market prices

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Measurement of NI - MethodsProduct Method – An illustration

Sectors Total value in Rupees Crores

Agriculture & allied activities 1000

plus Manufacturing industries 3000

plus Services & construction 4000

equals GDP at market prices 8000

plus Net factor income from abroad 1000

equals GNP at market prices 9000

Measurement of NI - MethodsThe Income Method• Also known as factor share method

• Sum of the incomes accruing to the basic factors of production used in producing the national products

Rent + wages + interests + profits + depreciation = GDP at factor cost

Plus net income from abroad = GNP at factor cost

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Measurement of NI - MethodsFactor Income Method – An illustration

Sectors Total value in Rupees Crores

Income from employment 1000

plus Gross profits of companies 2000

plus Gross profits of public sector 2000

plus Rent 2000

equals GDP at factor cost 7000

plus Net factor income from abroad 1000

equals GNP at factor cost 8000

Measurement of NI - MethodsThe Expenditure Method

• Measures NI at final expenditure stage

• Excluded all expenditure on intermediate goods

• Sum of all money spend by individuals, firms and government within a year = GDP at market prices (Y)

=) Consumption (C) + Investment (I) + Government Expenditure (G) + Exports and factor income from abroad (X) - Imports and factor income paid abroad(M)

Y = C + I + G + X - MNASEER SHAHZADA

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Measurement of NI - MethodsExpenditure Method – An illustration

Sectors Total value in Rupees

Crores

Consumer expenditure (C) 2000

plus Gross business spending (investment) (I) 3000

plus Govt. expenditure (G) 2000

equals Domestic expenditure at market prices (C + I + G)

7000

plus Exports & factor income from abroad (X) 3000

minus Imports & factor income paid abroad (M) 1000

equals GNP at market prices (C + I + G + X - M) 9000

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There are three types of omissions in the measurement of GDP

1) Activities that are not part of GDP by definition

Transfer payments & gifts received, second-hand sales (except brokerage), increase in share prices, etc..

2) Items left out because of measurement problem

All non-market transactions, unorganized sector, income through illegal means (black money), etc..

3) Items related to the welfare of the people

Quality of life, distribution of income, environmental damages, etc..

GDP Omissions

• Determining what is ‘final’ and what is not (problem of double counting)

• Evaluation of non-marketed goods and services

Example: - The goods and services produced and consumed at home, that never enter the market place

• The services of housewives, women at HHs.• Many economic activities by unorganized sector • Black money, black market items, income from illegal

activities and professions, etc.• Does not consider certain factors affecting people’s welfare

(like income distribution, environmental damages)

Problems of measuring GNP

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Exercise - 1

Particulars Rs. In crore

GNP at factor price 95,000

Indirect taxes 14,000

NDP at market prices 1,00,422

NNP at market prices 1,00,000

GNP at market prices 1,07,000

Personal income taxes 10,000

Corporate profit tax 6,500

Retained profit 30,000

The following information is extracted from the National Income Accounts of an economy for the year 2008-09

Compute (a) the value of depreciation; (b) the value of net factor income from abroad; (c) the value of subsidies; (d) the value of NDP at factor cost; (e) the value of national income; (f) the value of personal income; and (g) the value of personal disposable income

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Exercise - 2

Particulars Rs. In crore

NNP at factor price 4,73,246

Depreciation 61,809

Subsidies 19,431

Net Factor Income from abroad -6,833

Indirect taxes 87,043

Personal income taxes 9,759

Corporate taxes 7,300

Retained profit 6,758

The following information is extracted from the National Income Accounts of an economy for the year 2008-09

Compute (a) the value of GNP at market price; (b) the value of NNP at market price; (c) the value of NDP at market prices; (d) the value of NDP at factor cost; (e) the value of GNP at factor cost; and (f) the value of personal disposable income

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References1. Chapter 4 & 5, ‘Principles of Macroeconomics’

by Michael Melvin and William Boyes .

2. Chapters 1 & 2, ‘Macroeconomic Policy Environment’ by Shyamal Roy.

3. Chapter 2, ‘Macroeconomics’ by R. Dornbusch, S.Fischer, and R. Startz.

4. Chapter 2. Prof. A. Hamid Shahid

5. Chapter 2. Abel. Ben. bernanke