MEBE Merged End Sem

Introduction
to Economic
Analysis
Dr Vighneswara Swamy
Professor
What is economics?
Economics is the science that deals with the behaviour of people,
individuals, households, firms and the government concerned with the
production, distribution, and consumption of goods and services, or
the material welfare of humankind.
In simple terms, Economics is the study of how society manages its
scarce resources.
First ever recorded document on economics is from Kautilya in the
form of Arthashastra during 3 B.C.
Alfred Marshal was the first to use the term Economics in 1922.
DR. VIGHNESWRA SWAMY 2
What is Macroeconomics?
▪Macroeconomics is the study
of the behavior of the economy
as a whole.
▪It concerns the business

cycles that lead to
unemployment and inflation,
as well as the longer-term
trends in output and living
standards.

Microeconomics vs Macroeconomics
Microeconomics Macroeconomics
Microeconomics is the study of Macroeconomics is the study of
decision making by individual nationwide phenomena, such as
households and individual firms, and inflation,
how they interact in specific markets. unemployment, and economic growth.
Usefulness of Microeconomics: Usefulness of Macroeconomics:

Determination of demand pattern Income and employment determination
Determination of the pattern of supply Price level
Pricing Business cycles
Policies for improvement of resource allocation Balance of payments
Solution to the problems of micro-units Government policies
Interrelations between markets

Macroeconomics Objectives
The major objectives:
▪ Economic growth
▪ Full employment
▪ Price stability
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DR. VIGHNESWRA
Green Growth
▪ Green growth is a paradigm
in which green policies,
innovation, and investments
drive sustainable economic
development.
▪ Green economics is a
methodology of economics
that supports the
harmonious interaction
between humans and nature
and attempts to meet the
needs of both
simultaneously.
1-6 SWAMY
DR. VIGHNESWRA
Green Economy
▪ A green economy is defined as low carbon, resource efficient and
socially inclusive.
▪ UNEP championed the idea of "green stimulus packages" and identified
specific areas where large-scale public investment could kick-start a
"green economy“.
▪ In a green economy, growth in employment and income are driven by
public and private investment into such economic activities,
infrastructure and assets that allow reduced carbon emissions and
pollution, enhanced energy and resource efficiency, and prevention of
the loss of biodiversity and ecosystem services.
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DR. VIGHNESWRA
Why Green Economy?
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DR. VIGHNESWRA
The 5 Principles of Green Economy
1. The Wellbeing Principle 4. The Efficiency and Sufficiency
Principle
2. The Justice Principle 5. The Good Governance Principle
3. The Planetary Boundaries

Principle
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DR. VIGHNESWRA
Why Does Green Economy Matter?
▪An inclusive green economy green economy is one that
improves human well-being and builds social equity while
reducing environmental risks and scarcities.
▪An inclusive green economy is an alternative to today's

dominant economic model, which exacerbates inequalities,
encourages waste, triggers resource scarcities, and generates
widespread threats to the environment and human health.
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DR. VIGHNESWRA
Macroeconomic Goals
▪The goal of economic growth
▪The goal of low unemployment
▪The goal of low inflation
▪Price stability
▪International trade with export and import equilibrium
and exchange rate stability
▪Improved standard of living

Scope of Macroeconomics
Macroeconomics involves the study of economic aggregates
of nation/s:
◦ Economic growth
◦ Employment
◦ Inflation
◦ Aggregate demand and aggregate supply
◦ Economic policies – fiscal and monetary
◦ International trade – exports and imports
◦ Money supply
◦ Interest rate trends
The Power of Economic Analysis
▪Economic analysis is used in all decision making.

▪Economic analysis is a tool that can aid all decision
making.
▪The economic way of thinking provides a framework
for analyzing solutions to economic problems.

Macroeconomic Policy Instruments
A policy instrument is an economic variable under the control of
government that can affect one or more of the macroeconomic goals.
1. Fiscal Policy
Fiscal policy is the use of government expenditures and taxes to affect
aggregate demand and aggregate supply.
2. Monetary Policy
Monetary policy involves the use of interest rates to control the level and rate
of growth of aggregate demand in the economy.
Components of Macroeconomy
Macroeconomics focuses on:

1. households
2. firms
3. the government
4. the rest of the world

Market Arenas of Macroeconomy
Macroeconomics focuses on three broad market
arenas:
1. the goods-and-services market
2. the labor market
3. the money (financial) market

Macroeconomic Concepts
Output and National Business Employment Price International
Growth Income Cycle Stability trade
Output, Gross Domestic Depression Unemployment, Inflation, Exports and
Aggregate Product (GDP), , Labor force, Deflation, Imports,
output, Nominal Recession, Unemployment Price Trade
Economic income, Real Expansion rate stability Imbalances:
growth, income, surplus and
Productivity Gross National deficits,
growth, Income, Exchange
Real and Rate
Nominal
measures of
GDP and
Human Welfare
Importance of GDP
1. Gross Domestic Product (GDP) is the widely used measure
of an economy's output or production.
2. It represents the total dollar value of all goods and services
produced over a specific time period; you can think of it as
the size of the economy.
3. It has become widely used as a reference point for the
health of national and global economies.
4. When GDP is growing, especially if inflation is not a problem,
workers and businesses are generally better off than when it
is not.

Major Issues in Macroeconomics
1. What determines a nation’s long-run economic growth?
2. What causes a nation’s economic activity to fluctuate?
3. What causes unemployment?
4. What causes prices to rise?
5. How does global economic system affect nations’
economies?
6. How do the government policies help improve economic
performance?

The Role of Macroeconomists
Macroeconomic Macroeconomic Macroeconomic research Data
forecasting analysis development
To predict future To analyze and To understand the structure of Macroeconomists
economic trends - interpret events the economy in general – forms use data to assess
has some success as they happen – the basis for macroeconomic the state of the
in the short run. helps both analysis and forecasting. economy, make
In the long run private sector forecasts, analyze
too many factors and public To develop theories: policy
are highly policymaking. Economic theory: a set of ideas alternatives, and
uncertain. about the economy to be test theories.
organized in a logical framework.
Economic model: a simplified
description of some aspects of
the economy.
Keywords
Economics
Economic analysis
Macroeconomics
Production
Economic output
Economic growth
Prices
Income
Employment
Gross Domestic Product
Glossary
Closed Economy
An economy which is assumed not to take part in International Trade i.e. no exports and no imports.
Although no such economy exists in the world, this assumption is useful in model building.
Command Economy
A mode of economic organization in which the key economic functions Ä what, how and for whom
Ä are principally determined by the government directive. It is sometimes even called “centrally
planned economy”.
Fiscal Policy
The use of taxation and the government expenditure to regulate the aggregate level of economic
activity.
Monetary Policy
It deals with the actions taken by the Central Bank of a country to influence the money supply and
the interest rates to stabilize the economy. It is regarded as an indispensable tool of economic
management.
MCQ1
The study of Macroeconomics deals with
a) Economic behavior of individuals and firms
b) Use of natural resources in a country
c) Economic behavior of the government
d) Regulation of market place
e) Behaviour of the entire economy

MCQ1
The study of Macroeconomics deals with
a) Economic behavior of individuals and firms
b) Use of natural resources in a country
c) Economic behavior of the government
d) Regulation of market place
e) Behaviour of the entire economy

MCQ2
Which of the following is NOT the scope of Macroeconomics?
a) Economic growth
b) Employment
c) Inflation
d) Pricing of goods and services
e) Money supply

MCQ2
Which of the following is NOT the scope of Macroeconomics?
a) Economic growth
b) Employment
c) Inflation
d) Pricing of goods and services
e) Money supply

MCQ3
Which of the following statements about Macroeconomic is true?
a) Price is the main determinant of macroeconomics.
b) Partial equilibrium analysis is used in macroeconomics.
c) Influencing consumer behavior is the goal of macroeconomics.
d) Macroeconomic is the study of groups and broad aggregates of the
economy.
e) The external policy is the tool of macroeconomics

MCQ3
Which of the following statements about Macroeconomic is true?
a) Price is the main determinant of macroeconomics.
b) Partial equilibrium analysis is used in macroeconomics.
c) Influencing consumer behavior is the goal of macroeconomics.
d) Macroeconomic is the study of groups and broad aggregates of the
economy.
e) The external policy is the tool of macroeconomics

MCQ4
Which of the following is NOT a sector in the Five-sector
model of an economy?
a) Households
b) Firms
c) Private sector
d) Government
e) Rest of the world

MCQ4
Which of the following is NOT a sector in the Five-sector
model of an economy?
a) Households
b) Firms
c) Private sector
d) Government
e) Rest of the world

MCQ5
Monetary policy in India is decided by
a) The finance ministry of the Union Government
b) International Monetary Fund
c) Monetary policy committee in RBI
d) Securities Exchange Board of India
e) Banks Board Bureau

MCQ5
Monetary policy in India is decided by
a) The finance ministry of the Union Government
b) International Monetary Fund
c) Monetary policy committee in RBI
d) Securities Exchange Board of India
e) Banks Board Bureau

Thank you.
Vighneswara Swamy 33
That’s all for
this session!
Please take a look at the

additional reading materials
Vighneswara Swamy
34
Vighneswara Swamy
35
Chapter 4
Economic activity & performance
In this chapter we will explore:
4.1 Indicators of macroeconomic activity and per-

formance
4.2 Recent Canadian economic performance
4.3 National accounts and economic structure
4.4 Measuring GDP
4.5 Nominal GDP, real GDP and the GDP deflator
4.6 Per capital real GDP, productivity and stan-
dards of living
Macroeconomics is focused on three key indicators of the economy’s performance and the under-
lying explanations for their behaviour. The indicators are:
1. The rate of growth of real national income.

2. The rate of inflation.
3. The rate of unemployment.
Other aspects of the economy like interest rates, foreign exchange rates, wage rates, government
budgets, capital investment, commodity prices, housing and so forth are important to macroeco-
nomic analysis because they work to determine performance as measured by these three indicators.
Macroeconomics involves complex linkage and feedback effects that tie economic conditions and
economic policy to economic performance. Macroeconomic theories and models attempt to cap-
ture this complexity. They seek to understand and explain the causes of changes in economic
performance and the role for economic policy.
Internationally the persistent effects of what seemed to be a local crisis in the US housing market
triggered the Great Recession of 2009. International linkages among financial markets spread the
effects across European and other financial markets. Government bailouts of major banks and
monetary and fiscal stimulus to fight falling output and employment resulted in unprecedented
government deficits and historically low interest rates. International financial and fiscal linkages
were much stronger than expected initially.
75
76 Economic activity & performance
In Canada, the interest rates set by the Bank of Canada were reduced to the lowest historical
level. Governments continue to focus their budget policies on reducing or eliminating budget
deficits caused by earlier economic conditions and policy decisions, despite pressing needs for
infrastructure investment. The recent collapse in crude oil and other commodity prices raise new
concerns for domestic economic growth and employment.
By mid-2016 energy and commodity prices had recovered and the new government’s expansionary
fiscal policy supported a mild economic recovery. Growth in Canadian economic activity and
employment increased but, by Bank of Canada estimates, the economy still remained below ‘full
employment’ in the first quarter of 2017.
Macroeconomic theory and models emerged from an earlier major financial collapse and crisis
followed by the depression years of the 1930s. Although today’s economies are larger and more
complex they still behave by the same basic principles.
To understand the different dimensions of economic activity, economic conditions and macroeco-
nomic policies, we need a framework that captures how they are related and how they interact.
Macroeconomics provides that framework, using consistent and comprehensive system of defini-
tions for the measurement of economic activity provided by the national accounts.
4.1 Macroeconomic performance

Output, price, and employment are three key dimensions of macroeconomic activity. Output is a
measure of the total quantity of goods and services produced in the economy. It is also a measure
of the incomes generated by that production. Price or the price level in macroeconomics is the
weighted average of the market prices of all final goods and services produced. The price level
reflects the costs of production in the economy. Employment is a measure of the number of jobs
involved in the production of goods and services, or, in more refined terms, the number of hours of
labour input required to produce the economy’s output. Economic performance is judged by how
these measures change over time.
Output and its rate of growth are measured in terms of real gross domestic product (real GDP).
It is the quantity of final goods and services produced in the economy in a specific time period,
such as one year, measured in the market prices of a base year, 2007 for example. (It may also
be called GDP in constant 2007 dollars). The production of goods and services generates incomes
equal to the value of those goods and services. As a result, real GDP is also the real income in the
economy and the quantity of goods and services the economy can afford to buy.
Real GDP: the quantity of final goods and services produced by the economy in a
specified time period.
In an economy with a growing population and labour force, growth in real GDP is necessary to
maintain standards of living. In the Canadian economy, real GDP changes from year to year. By
measuring real GDP in the prices of a base year, the changes seen in real GDP are the result of
4.1. Macroeconomic performance 77
changes in the quantities of goods and services produced, and not the result of changes in prices.
This distinction is important: Increased quantities of goods and services provide for increased
standards of living in the economy, increases in prices do not. As a result, economic growth
is defined as an increase in real GDP, and the annual rate of economic growth is the annual
percentage change in real GDP. This is the first key indicator of economic performance.
The rate of growth in real GDP is calculated as follows:
Real GDPyear 2 − Real GDPyear 1

Rate of growth of real GDP = × 100 (4.1)
Real GDPyear 1
Economic growth: an increase in real GDP.
Rate of economic growth: the annual percentage change in real GDP.
Recent measures of real GDP in Canada provide an example of economic growth and the calcu-
lation of the rate of economic growth. In the year 2016, real GDP in Canada measured in 2007
dollars was $1,781 billion. One year earlier, in 2015, real GDP in 2007 dollars was $1,751 billion.
Using these data:
$1, 781 − $1, 751

Rate of growth of real GDP in 2016 = × 100 = 1.7%
$1, 751
The price level in the economy is a measure of the weighted average of prices of a wide variety
of goods and services. The Consumer Price Index (CPI), for example, compares the cost of a
fixed basket of goods and services bought by the typical household at a specific time with the cost
of that same basket of goods and services in the base year. It is the most widely used indicator of
prices in Canada and is often referred to as the “cost of living.”
Price level: a measure of the average prices of all goods and services produced in the
economy.
Price index: a measure of the price level in one year compared with prices in a base
year.
Consumer Price Index (CPI): a measure of the cost of living in any one year com-
pared to the cost of living in a base year.
The Consumer Price Index is a more comprehensive measure of the change in prices from one
year to the next, but the simple example in Example Box 4.1 illustrates the how such an index is
constructed and what it tells us.
Example Box 4.1: Constructing a price index
A simple example illustrates the construction of a price index. Suppose a survey of expendi-
tures by university students in the year 2006 gives the information reported in the first three
columns in the following table:
University student weekly expenditure basket (Base year 2006)

Quantity 2006 Price 2006 Cost 2011 Price 2011 Cost
Pizza 5 $7.50 $37.50 $8.50 $42.50
Hamburger 5 $2.50 $12.50 $2.25 $11.25
Coffee 10 $1.00 $10.00 $1.25 $12.50
Movies 1 $10.00 $10.00 $8.00 $8.00
Bus fare 7 $1.50 $10.50 $1.85 $12.95
Total $80.50 $87.20
This table gives us the cost of weekly expenditures on a basket of five items and the weight
of each item in the total expenditure. If we choose 2006 as our base year then the cost of the
basket in 2006 prices, $80.50, has an index value of 100 [($80.50/80.50) × 100]. In other
words we have a Student Price Index:
SPI2006 = 100.0
Now we see in the last two columns of the table that this same basket of goods and services
in the prices of 2011 would cost $87.20. Then our SPI in 2011 would be:
(Cost of basket in 2011)/(Cost of basket in 2006) × 100 = ($87.20)/($80.50) × 100 = 108.3
The index tells us that even though the prices of some things went up and others went down
the Student Price Index increased by 8.3%. This was the weighted average increase in prices
and the increase in the cost of student expenditures.
Today, the base year for the consumer price index is 2002 with a value of 100. Statistics Canada
uses a fixed basket classified under eight consumer expenditure categories. The weight or impor-
tance of each category is its share of expenditure as determined by consumer expenditure surveys.
By visiting the Statistics Canada website, www.statcan.gc.ca, and selecting Consumer Price In-
dex in the Latest Indicators table on the right side of the home page, you can scroll down to a table
showing the components of the CPI.
For 2015 Statistics Canada reported a CPI of 126.8 compared to a CPI of 100.0 in 2002. That
meant the cost of the basket of goods in 2015 was 26.8 per cent higher than it was in 2002. Prices
and the cost of living increased over the 13-year period. At the end of 2016 the CPI was 128.7.
Prices had increased again. Inflation is defined as a persistent rise in the general price level as
indicated by these increases taking the change, as a percentage, in the price level the previous year.
Inflation: a persistent rise in the general price level.
The inflation rate is calculated using the same method used for calculating the growth rate in real
GDP. For example, using CPI values for 2015 and 2016:
CPI2016 − CPI2015
Inflation rate for 2016 = × 100 (4.2)
CPI2015
128.7 − 126.8
Inflation rate for 2016 = × 100 = 1.5%
126.8
Statistics Canada also collects and publishes information on the Canadian labour market. It uses
a monthly Labour Force Survey of approximately 50,000 Canadian individuals 15 years of age or
over living in the provinces of Canada, excluding full-time members of the armed forces, those
persons living on Indian reserves, and those in institutions such as penal institutions, hospitals,
and nursing homes. The survey provides the data used to estimate the size of the labour force,
employment, and unemployment.
Employment is defined as the number of adults (15 years of age and older) employed full-time and
part-time and self-employed. Unemployment covers those not working but available for and seek-
ing work. The civilian labour force is those adults who are employed plus those not employed but
actively looking for jobs. Based on these concepts, and data on the surveyed population, Statistics
Canada reports three key labour market indicators, namely: The participation rate, the unemploy-
ment rate, and the employment rate. Employment and unemployment receive most of the media
attention and have become familiar indicators of economic conditions. There are, however, two
other underlying labour market measures that deserve attention when interpreting the employment
and unemployment rates.
Labour force: adults employed plus those not employed but actively looking for
work.
Employment: number of adults employed full-time and part-time and self-employed.
Unemployment: number of adults not working but actively looking for work.
The participation rate is the proportion of the surveyed population that is either working or un-
employed. It measures the size of the labour force relative to the surveyed population. The partic-
ipation rate changes as people become more optimistic about finding employment, or discouraged
by periods without employment. Discouraged workers want to work but are no longer looking for
work because they believe suitable work is not available. As a result they are excluded from the
measurement of the labour force and reduce the participation rate. Changes in the participation
rate change the size of the labour force and the unemployment rate even if employment and the
population are constant.
Participation rate: percent of the population that is either working or unemployed.
Labour force
Participation Rate = × 100 (4.3)
Population 15+ yrs
The unemployment rate is the number of unemployed persons expressed as a percentage of the
labour force. The size of the labour force depends on the participation rate, which reflects the
choices people make about looking for work. The unemployment rate will rise if people become
more optimistic about job prospects and begin to look for work, increasing the participation rate
and the labour force. On the other hand, the unemployment rate will decline if some people become
discouraged and give up looking for work, reducing the participation rate and the labour force.
Unemployment rate: the number of unemployed persons as a percentage of the

labour force.
The unemployment rate is calculated as follows:
Labour force − employment

Unemployment Rate = × 100 (4.4)
Labour force
Unemployment as measured by the broad unemployment rate has three important components.
Cyclical unemployment is unemployment that would be eliminated by a higher level of economic
activity without putting increased pressure on wage rates and inflation. Frictional unemployment
comes from the dynamics of the labour market as changing labour force participation and employ-
ment opportunities mean that it takes time to match job openings with job candidates. Structural
unemployment reflects differences in labour force characteristics and employment opportunities
as the structure of the economy changes. In combination, frictional and structural unemployment
make up the “full employment” level of unemployment. The corresponding unemployment rate
is defined as the natural unemployment rate. In recent years in Canada, estimates of frictional
and structural unemployment suggest a natural unemployment rate of about 6.0 percent. An un-
employment rate persistently below 6.0 percent would create inflationary pressure in the labour
market and the economy.
Cyclical unemployment: would be eliminated by higher levels of economic activity.
Frictional unemployment: a result of the time involved in adjusting to changing

labour force and employment opportunities.
Structural unemployment: caused by changes in economic structure relative to

labour characteristics.
Natural unemployment rate: the unemployment rate at “full employment”.
Employment rate: percent of the population 15 years of age and over that is em-
ployed.
Employment rates provide a different perspective on labour market conditions because they are
not affected by changes in the participation rate, which can change unemployment rates. If some
people become discouraged and stop looking for work the participation rate, the labour force and
the unemployment rate decline, but the employment rate is unchanged. The employment rate is
calculated as:
Employment
Employment Rate = × 100 (4.5)
Population 15+ yrs
Table 4.1 gives recent data on the Canadian labour force and labour market conditions in terms of
the Participation, Employment and Unemployment rate concepts.
Table 4.1: The Canadian Labour Market, February 2017 (thousands of persons and percent)
1. Non-institutional population 15+ yrs 29,764

2. Labour force 19,575
3. Employment 18,289
4. Unemployment 1,286
5. Participation rate [(2)/(1) × 100] 65.8%

6. Employment rate [(3)/(1) × 100] 61.4%
7. Unemployment rate [(4)/(2) × 100] 6.6%
Source: Statistics Canada, CANSIM Table 282-0087
Almost every day the media discuss some aspects of economic growth, inflation, and employment.
Often these discussions ignore the requirement that employment must grow faster than the growth
in the labour force if unemployment is to decline. Good news about ‘job creation’ needs to be
tempered by news on labour force growth. These issues often play large roles in elections and
discussions of economic policy. In the chapters that follow, we will study causes of changes in
output, income, prices and inflation, and employment and unemployment. As a background to that
work, consider recent Canadian economic performance.
4.2 Canadian economic performance

The positive relationship between economic performance and standards of living motivates the
study of macroeconomics and macroeconomic policy. The ideal would be an economy in which,
starting with full employment of labour and capital equipment, the rate of growth of real GDP
matched the rate of growth of the labour force and growth in labour productivity, at a low and
stable rate of inflation. This is sometimes referred to as a ‘Goldilocks Economy’ – neither too hot
nor too cold, just right.
Figures 4.1 to 4.4 provide a more detailed look at the actual rate of growth of real GDP, the rate of
inflation, and unemployment rate in Canada over the 2000–2016 time period. They show the trends
and annual variations in these measures of economic performance. Understanding the causes of
these short-term fluctuations in economic performance, their effects on standards of living and the
economic policy questions they raise, are major reasons for studying macroeconomics.
Figure 4.1: Real GDP in Canada 2000–2016
1 900 000
1 800 000
Great Recession
1 700 000
millions 2007 $
1 600 000
1 500 000
1 400 000
1 300 000
2000
2002
2004
2006
2008
2010
2012
2014
2016
Year

4.2. Canadian economic performance 83
Figure 4.2: Annual Real GDP Growth in Canada, 2001–2016
2
%
−2
−4
2000
2002
2004
2006
2008
2010
2012
2014
2016
Year
Figure 4.1 shows the substantial growth in real GDP over the 2000–2016 period. It also shows that
growth was not steady. Real GDP did increase from 2000–2008 with annual growth rates ranging
from 1.5-3.0. Then the real GDP declined sharply by 3.0 percent in 2009. This and other times of
negative growth in real GDP are called recessions. Indeed the fall in real GDP in 2009, the largest
such decline since the 1930s, is now called the ‘Great Recession’.
Recession: decline in economic activity, often defined as two consecutive quarters of

negative growth in real GDP.
Figure 4.2 shows more clearly the considerable fluctuations in real GDP annual growth rates and
the negative growth rate of the Great Recession. Even when the trend in growth is positive, fluc-
tuations in growth rates can have negative effects on standards of living. They are reflected in
changes in employment, changes in incomes and changes in markets that can make life difficult
for those affected. We study macroeconomics to find explanations for the causes and effects of
these fluctuations in economic activity that will guide stabilization policies.
Figure 4.3 shows annual inflation rates in Canada since 2000. These show the relative stability of
Canadian inflation in the years leading up to the Great Recession. That pattern changed after 2008
with the effects of lower output growth and higher unemployment on prices and wage rates.
Figure 4.3: Annual Inflation Rates in Canada, 2000–2016
2
%
−1
2000
2002
2004
2006
2008
2010
2012
2014
2016
Year
Our recent experience with low and stable inflation rates in the 2000–2016 period is quite different
from past experience. In the late 1980s and early 1990s annual inflation rates were at times higher
than 10 percent. We will examine the roles that monetary policies and recessions played in these
changes in inflation rates.
Fluctuations in growth rates and inflation rates are also accompanied by fluctuations in unemploy-
ment rates. Annual unemployment rates plotted in Figure 4.4 have fluctuated between 6 percent
and 8.3 percent. Although employment has grown over time, when job creation has at times fallen
short of the growth in the labour force, unemployment rates rise. At other times, strong real GDP
growth and job creation have lowered the unemployment rate. The falling unemployment rates
from 2002 to 2007 and again from 2009 to 2015 coincided in time with the continuous growth in
real GDP we saw in Figure 4.1.
4.3. National accounts 85
Figure 4.4: Annual Unemployment Rates in Canada 2000–2016
8.5
Great Recession
8.0
7.5
7.0
%
6.5
6.0
5.5
5.0
2000
2002
2004
2006
2008
2010
2012
2014
2016
Year
The sharp rise in unemployment in 2009 and the persistence of unemployment rates higher than
those in earlier years give us an example of the way growth in real GDP and employment are tied
together. The recovery of GDP growth after the Great Recession has not been strong enough to
offset modest growth in the labour force and lower unemployment rates to pre-recession levels.
4.3 National accounts

National accounts provide the framework that is essential for consistent definitions and measure-
ment of spending, output, and incomes. However, it is important to recognize that this is an ac-
counting system that describes the economy, not an economic model that explains the economy’s
behaviour. That comes later.
The national economy involves all households, businesses, and governments that make decisions
about employment, output and expenditures. The results of individual decisions made by these
economic units are measured by the economy’s total spending, output, and income. The circular
flow diagram in Figure 4.5 shows the relationship between spending, output, and income.
Circular flow diagrams: show the flows of money payments, real resources, and
goods and services between households and businesses.
Figure 4.5: Circular flows in the economy
Spending on Goods & Services

$ $
Output of Goods & Services
Households Businesses
Land, Labour & Capital
$ $
Factor incomes paid to Households
We start with the simplest of economies. There are only households and businesses; no government
and no trade with other countries. Households own the factors of production: Labour, land, capital,
and entrepreneurship. Businesses use these factors of production to produce outputs of goods and
services. Businesses pay households for the factor services they use and recover these costs by
selling their output to the households.
Figure 4.5 shows the circular flow of inputs to production, outputs of goods and services, costs
of the inputs to production, and receipts from sales. The upper half of the diagram, above the
horizontal line, shows the outputs of goods and services supplied by business to households and
household expenditures on those goods and services. The lower half of the diagram shows the
factor services of labour, land capital, and entrepreneurship supplied by households to business in
exchange for the factor incomes: wages, rent, interest, and profit.
The figure also suggests an alternative way to look at activity in the aggregate economy. The inner
loop in the diagram shows the flows of real factor services between households and businesses.
Households provide factor services to business and get goods and services in return. In modern
economies this exchange of factor services for goods and services is facilitated by the use of money
as a means of payment. The outer loop in the diagram illustrates the flows of money payments made
by business to buy factor services, and by households to buy goods and services produced by busi-
ness. Business pays wages, rent, interest, and profits to households and finances those costs with
their receipts from sales to households. To keep the example simple, we assume that households
spend all the income they receive from the business sector on goods and services produced by the
business sector.
4.4. Measuring GDP 87
Figure 4.5 illustrates four ways to measure economic activity, namely:
1. the output of goods and services at market prices;

2. the total expenditure on goods and services at market prices;
3. the inputs to the production of goods and services costed at market prices; and
4. the incomes received by households for providing factor inputs to production.
The four rectangles in the diagram show these four alternative but equal measurements.
The accounting framework gives the same measure of total economic activity whether we use the
market value of output, total spending on that output, inputs to production, or the factor incomes
received by households in return for those inputs.
This circular flow model is kept very simple to illustrate the basic accounting principle:
Market value of output = total expenditure
= market value of factor services
= household income.
While the principle illustrated by the circular flow is sound, the economy in Figure 4.5 is too
simple. It does not allow households to save or businesses to invest. It leaves out government
expenditures and taxes, and transactions between households and businesses with the rest of the
world. Including those aspects of economic activity would make our model more complex, and we
would need a comprehensive system of national accounts to describe and measure it. But the basic
accounting principle would be the same: the four ways to measure total activity in the economy
give, by definition, the same answer.
4.4 Measuring GDP

Nominal GDP is measured using market prices and a specific time period. It is not possible to
add up the final physical outputs of many different businesses and arrive at a meaningful result.
Instead, because we have a ‘money economy’, we let current market prices determine the money
values of these different outputs. Then the total market value can be found by adding up the money
values. Nominal GDP is the market value at current prices of all final goods and services.
Furthermore, the outputs of goods and services occur over time, not all at once. They flow over
time and must be measured relative to time. GDP measured over three-month and one-year time
periods are reported as quarterly GDP and annual GDP. Annual nominal GDP for any year is the
value of the final goods and services produced in that year at the prices of that year.
Final goods and services: goods and services are purchased by the ultimate users.
In Canada, Statistics Canada uses the Canadian System of National Accounts (CSNA) to measure
GDP. This framework is based on the circular flow concept we have discussed, but is applied to the
complexity of the actual economy.
Although earlier in this chapter we defined and discussed real GDP, measured at prices of a base
year national accounting measures nominal GDP at current prices. The CSNA produces three
measurements of nominal GDP:
1. Output-based GDP is the sum of value added (output less the cost of goods and services
purchased from other business) by all industries in Canada;
2. Income-based GDP records the earnings generated by the production of goods and services;
and
3. Expenditure-based GDP is equal to expenditure on final goods and services produced.
Nominal GDP: the output of final goods and services, the money incomes generated
by the production of that output, and expenditure on the sale of that output in a specific
time period.
These three alternative measures of GDP provide importantly different perspectives on the level of
national economic activity. The output and income measures describe the supply side of the econ-
omy in terms of goods and services produced, and cost of production. The expenditure measure of
GDP describes the demand side of the economy.
Output-based GDP
To measure output in the economy, and the contribution of particular businesses or industries to
that output, we use the value-added approach to GDP. Value added measures the net output of
each industry. To find the value added (net output) of a particular business or industry, the costs of
the goods and services purchased from other businesses and industries are deducted from the value
of the final product. National, or all-industry GDP, is then the sum of GDP by industry.
Value added: the difference between the market value of the output of the business
and the cost of inputs purchased from other businesses.
This method recognizes that businesses buy inputs to production from other businesses as well
as from households. Automakers like General Motors and Honda buy parts and components like
tires and windshields from other businesses, and include the costs of those inputs in the prices of
the finished cars they sell. They also buy services like accounting, advertising, and transportation
from service producers. Similarly, pizza makers buy cheese and pepperoni from cheese factories
and meat processors. If we were to add up the outputs of auto parts manufacturers, cheese makers,
meat processors, pizza makers, General Motors, and Honda in our measurement of nominal GDP,
we would overstate GDP by double counting. The cheese would be counted once at the cheese
factory and again in the pizza. The same applies to the tires and windshields of the new cars.
To avoid double counting, we use value added, the increase in the value of goods and services as
measured by the difference between market value of output and the cost of intermediate inputs
bought from other businesses. Or we could count only the outputs sold to final users. Notice that
4.4. Measuring GDP 89
total GDP by our definition measures the output of final goods and services.
Intermediate inputs: services, materials, and components purchased from other

businesses and used in the production of final goods.
Consider a simple example. A coffee shop sells 100 cups of coffee an hour at a price, before tax,
of $1.50. To make 100 cups of coffee the shop uses 2 kilos of ground coffee costing $10.00 per
kilo, 25 litres of pure spring water costing $0.40 a litre, and electricity and dairy products costing,
in total $20. The coffee shop’s sales per hour are $150 using inputs costing $50. Its value added
is $150 − $50 = $100. As we will see shortly, this value added, or $100, covers the labour costs,
rent, interest expenses, and management costs of the business, for producing 100 cups of coffee an
hour.
Table 4.2: Outputs of selected industries in GDP, Canada 2016 (percent shares)
All industries 100.0

Goods producing industries 29.5
Service producing industries 70.5
Agriculture, forestry, fishing, etc. 1.7

Mining, oil and gas extraction 8.2
Construction 7.0
Manufacturing 10.4
Wholesale and retail trade 11.2
Transportation 4.5
Finance, insurance and real estate 20.3
Professional, scientific and management 8.6
Health and social assistance 6.7
Educational 5.2
Public administration 6.4
All other 9.8
Source: Statistics Canada, CANSIM Table 379-0031 and author’s calculations
Table 4.2 shows the industrial structure of output in Canada in 2016, based on the percentage
shares of selected industries in Canadian GDP. Industry outputs are measured by value added.
The data illustrate the importance of service-producing industries to economic activity in Canada.
This industrial structure is typical of today’s high-income economies and raises many interesting
questions about the relationship between economic structure, performance, and growth. However,
when our main interest is in the total level of economic activity rather than its industrial structure,
the expenditure-based and income-based measures of GDP are used.
Expenditure-based GDP and income-based GDP

In the national accounts, expenditure based GDP and income based GDP are equal by definition.
Table 4.3 provides an example using the actual accounts for Canada in 2016Q4. Expenditure
categories and their shares in total expenditure are recorded in the left hand side of Table 4.3.
Income categories and indirect taxes shares and their shares are recorded on the right-hand side.
Table 4.3: Canadian National Accounts 2016Q4

($ billions at current prices and seasonally adjusted at annual rates and % GDP)
Expenditure Measures Incomes Measures

At market price $ % By income source $ %
C by households 1,196.1 57.8 Employee compensation 1,066.0 51.5
I by business 455.3 22.0 Gross operating surplus 530.7 25.7
G by government 435.8 21.1 Gross mixed income 242.0 11.7
X exports 654.1 31.6 Net indirect taxes 228.2 11.0
IM imports −672.7 −32.5
Statistical discrepancy −0.8 0.0 Statistical discrepancy 0.8 0.0
GDP at market price 2,067.8 100.0 GDP at market price 2,067.8 100.0
Source: Statistics Canada, CANSIM Tables 380-0063 and 380-0064
Expenditure-based nominal GDP adds up the market value of all the final goods and services
bought in a given time period, say one year. The national accounts classify this final expendi-
ture into five main categories: Consumption, investment, government expenditure, exports, and
imports.
For expenditure, the national accounts classification system is essential for our study of macroe-
conomic activity for two reasons. First, the classification scheme covers final expenditure in the
economy completely; nothing is omitted. Second, the categories represent expenditure decisions
made for different reasons in different parts of the economy and the percentage share or importance
of each in final expenditure. Understanding expenditure decisions is critical to the work that lies
ahead. Defining the expenditure categories is the first step.
Applying a name to each expenditure category in the table and using the notation attached gives:
GDP = consumption + investment + government expenditure + exports − imports
4.5. Nominal GDP, real GDP & the GDP deflator 91
or
GDP = C + I + G + X − IM (4.6)
For macroeconomic theory and models, this expenditure GDP is the foundation of theory of ag-
gregate demand introduced in Chapter 5 and developed in detail in later chapters.
Income-based GDP adds up the factor costs of production of all goods and services plus the net
in direct taxes included in market price. The national accounts classifications of factor incomes
correspond to labour income, corporate profit, unincorporated business income plus investment
income, and depreciation. The table also shows the percentage share of each category in GDP and
thus the relative importance of each in income or cost respectively. The income categories are:
Employment compensation (W ), gross operating surplus (corporate profit) (GCS), gross mixed
income (unincorporated business income plus investment income) (GMI) and net indirect taxes
(TIN ). (The allowance for depreciation of capital is included in GCS and GMI.) Then GDP at
market price is:
GDP = W + GCS + GMI + TIN (4.7)
This income based GDP measures total cost of production. The first three components W , GCS
and GMI are factor costs of production including the depreciation of capital equipment used in
production. Net indirect tax TIN is the revenue generated by taxes applied to goods and services
and included in final price. An aggregate supply function for the economy involves these costs of
production in relation to total output. Aggregate expenditure at market prices is the revenue that
producers receive to cover these costs.
To construct a macroeconomic theory and model of the economy we must explain the linkages,
feedbacks and interactions among the elements of the economy defined by national accounting
conventions. These linkages, feedbacks and interactions are the important relationships that work
together to explain how this economic system determines GDP, business cycle fluctuations in GDP,
inflation, and employment.
4.5 Nominal GDP, real GDP & the GDP deflator

We have used real GDP to measure growth and the growth rate in the beginning of this chapter, and
then nominal GDP as recorded in the National Accounts. Now we need to look carefully at both
concepts and the relationship between them, which is the GDP deflator, a measure of the general
price level. Nominal GDP measures output and incomes based on current market prices for goods
and services and factors of production. As a result, changes in nominal GDP from one period to
the next might be the result of changes in prices of final outputs and factor inputs, or the result of
changes in the quantities of final outputs and factor inputs, or some combination of the two. Since
it is physical quantities of goods and services that yield satisfaction or utility, it can be misleading
to judge the economy’s performance by looking at nominal GDP. For that purpose we need real
GDP, as we discussed earlier in this chapter. Real GDP, or GDP in constant prices, measures the
value of goods and services produced in any given year using the prices of a base year. In this way,
real GDP adjusts changes in GDP for changes in prices by measuring GDP in different years in
constant prices.
Table 4.4: Nominal and real GDP
2007 2017 % change

Quantity blue jeans 4,000 5,000 25
solar panels 2,000 4,000 100
Price in current $ blue jeans 25 50 100
solar panels 100 60 −40
Current value blue jeans 100,000 250,000 150
solar panels 200,000 240,000 20
Nominal GDP 300,000 490,000 63
Value in 2007 $ blue jeans 100,000 125,000 25
solar panels 200,000 400,000 100
Real GDP 300,000 525,000 75
GDP deflator 100 93.3 −6.7
To illustrate this important point, Table 4.4 shows a simple economy that produces both consumer
goods, blue jeans, and capital goods, solar panels. In this economy nominal GDP rises from
$300,000 to $490,000 between 2007 and 2017, a 63 percent increase measured in current prices as
a result of changes in both quantities and prices. If we take 2007 as the base year, we can measure
real GDP in 2017 by valuing output quantities in 2017 using 2007 prices. This gives real GDP in
2017 of $525,000 in prices of the base year. In the example in the table, quantities of both products
rise over the period but the price of blue jeans rises while the price of solar panels falls. As a result
the rise of about 75 percent in real GDP gives a true picture of the extra quantity of goods available
in the economy in 2017 compared with 2007. It eliminates the change in nominal GDP that was
the result of the fall in the average price level by 6.7 percent between 2007 and 2017 as a result of
the fall in the price of solar panels.
The GDP deflator

The Canadian economy is obviously more complex than this economy. We have seen that GDP
includes expenditures by households, governments, businesses, and residents of other countries
who supply us with imports and buy our exports. To convert nominal GDP to real GDP we need to
use an index that includes what is happening to the prices of all these different goods and services.
This index is called the GDP deflator.
4.5. Nominal GDP, real GDP & the GDP deflator 93
GDP deflator: index of current final output prices relative to base year prices.
If we have data for both nominal and real GDP, we can calculate the GDP deflator as the ratio of
nominal GDP to real GDP expressed as an index with a value of 100 in the base year.
Nominal GDP
GDP deflator = × 100 (4.8)
Real GDP
The GDP deflator differs from the consumer price index (CPI) illustrated in Example Box 4.1
and used to measure inflation in consumer prices and the cost of living. First, the CPI is based
on a “representative basket” of goods and services that consumers buy, while the GDP deflator is
comprehensive and covers all the goods and services included in national accounts. Second, the
CPI changes over time with changes in the prices of the basket of consumer goods and services.
The GDP deflator, by contrast, is built on the base year prices. It changes over time as the current
prices change relative to base year prices. In other words the GDP deflator is used to “deflate”
the dollar value of current 2017 output to what value it would be in 2007 prices, while the CPI
measures the increase in the cost of the “basket” of consumer goods and services.
But why does the GDP deflator change over time? From our earlier discussion of the national in-
come accounting framework, we can see that costs of production and net indirect taxes are included
in the general level of market prices measured by the GDP deflator. Nominal GDP measured by
the income approach is reported in Table 4.3. It is the sum of incomes paid to factor inputs to pro-
duction, plus depreciation allowances and net indirect taxes. These components of nominal GDP
are the costs of production, gross profits, and taxes that are built into the market prices of the goods
and services.
The general price level in the economy is the dollar amount paid for a ‘unit of output’ and, sub-
tracting indirect taxes, the revenue received by producers for the sale of ‘unit of output’. Revenue
per unit of output must cover costs per unit of output, including expected profit, for producers to be
willing to continue operations. Changes in costs must be covered eventually by changes in prices.
Or if market conditions raise prices—think about crude oil production or lumber production—
producers will increase output, as long as higher prices cover higher costs.
Summarizing from the national accounts gives three components of cost per unit of output:
1. employee compensation per unit of output, W /Y ;

2. gross business income per unit of output, (GCS + GMI)/Y ; and
3. net indirect tax per unit of output, TIN /Y .
Changes in the sum of these three components of the price level must change both price and
nominal GDP, whether we measure nominal GDP by the income or the expenditure approach. The
GDP deflator is an index of this price level in any particular year relative to a chosen base year.
However, the accounting framework does not explain the causes of change in the price level. That
requires explanations of changes in unit labour costs, of producer output and pricing decisions and
information on the net indirect tax rate. Those explanations are parts of an economic model of the
supply side of the economy.
To show the empirical importance of the distinction between real and nominal GDP, Table 4.5 gives
Canadian data over the period 2004 to 2016. Nominal GDP rose from $1,331 billion in 2004 to
$2,027 billion in 2016. Without knowing what happened to prices of goods and services in general,
we cannot judge what happened to the quantity of output over that period. To answer this question
we use the GDP deflator to convert nominal GDP to real GDP in the prices of the base year 2007
as follows:
GDPyear t
Real GDPyear t = × 100 (4.9)
GDP deflator
Table 4.5: Canadian nominal and real GDP 2004–2016
2004 2008 2012 2016

Nominal GDP (billions $) 1,331 1,653 1,823 2,027
GDP deflator (2007=100) 91.4 104.0 109.2 112.9
Real GDP (billions 2007 $) 1,456 1,589 1,669 1,796
Source: Statistics Canada, CANSIM Tables 380-0064 and 380-0066
For example, in 2016, nominal GDP was $2,027 billion and the GDP deflator (2007 = 100) was
112.9. Real GDP measured in constant 2007 dollars was then:
2027
Real GDP2016 = × 100 = 1795.4 in 2007 dollars
112.9
When converted to constant dollars, the change in real GDP is much smaller than the change in
nominal GDP. Over the 2004–2016 period shown in the table, real GDP increased by 23.4 percent
compared to a 52.3 percent increase in nominal GDP. On average, prices in 2016 were 23.5 percent
higher than in 2004. Clearly, it is important to distinguish between nominal and real GDP.
4.6 Per capita real GDP

Real GDP is a simple measure of the total real income and output of an economy. The percentage
change in real GDP we saw in Figures 4.1, 4.2 and 4.3 shows how fast the economy is growing. But
we are also interested in what is happening to productivity, the standard of living in the economy
and how they change over time. For a given real GDP, the larger the population, the lower is
productivity and the smaller is the quantity of goods and services per person. To get a simple
measure of the standard of living enjoyed by a person in the economy it is better to look at per
capita real GDP, which adjusts for population. Whether or not growth in total GDP improves
4.6. Per capita real GDP 95
standards of living depends also on what is happening to the size of the population. To find per
capita real GDP for a country, which is real GDP per person, we simply divide real GDP by
population.
Per capita real GDP: real GDP per person.
Real GDP
Per capita real GDP = (4.10)
Population
The study of short-run macroeconomics is strongly motivated by the negative effects of recessions
on national standards of living. Figure 4.6 shows the negative effects of recessions on per capita
GDP in 1982, 1991, and 2009.
Figure 4.6: Quarterly Rates of Growth in Per Capita Real GDP in Canada, 1982–2016
2
%
−2
−4
−6
1982Q1
1984Q1
1986Q1
1988Q1
1990Q1
1992Q1
1994Q1
1996Q1
1998Q1
2000Q1
2002Q1
2004Q1
2006Q1
2008Q1
2010Q1
2012Q1
2014Q1
2016Q1
Year and Quarter
Source: Statistics Canada, CANSIM Table 380-0064 and Series V1
Macroeconomic models are built to help us understand the causes of fluctuations in real GDP,
employment, and the price level. Understanding the workings of the economy is essential for the
design and implementation of monetary and fiscal policies that contribute to economic stability
and protect standards of living.
In longer time horizons macroeconomics seeks to understand and explain the growth of real GDP
that is essential to protect and improve standards of living as population grows. Growth also
increases the capacity of the economy to direct its resources to a wider range of activities that may
include improvements in the quality of goods and services produced or reductions in the effects of
growth on social and environmental conditions.
Limitations of real GDP

Because we use GDP to measure the output and income of an economy, the coverage should be
as comprehensive as possible. We should also recognize that the composition of GDP and the
distribution of income are important to a country’s standard of living.
In practice, we encounter several problems when including all production in GDP. First, some
production causes noise, pollution, and congestion, which do not contribute to economic welfare.
Current national and international concern about greenhouse gases and climate change is a clear
and obvious example of the issues involved. We should adjust GDP for these costs to evaluate
standards of living more accurately. This is sensible but difficult to do. Recent policy changes by
governments to impose carbon taxes on fuels and fuel efficiency targets for automobiles aim to
reduce some greenhouse gases. But most such nuisance goods are not traded through markets, so
it is hard to quantify their output or decide how to value their costs to society.
Similarly, many valuable goods and services are excluded from GDP because they are not marketed
and therefore are hard to measure. These include the home cleaning, maintenance, and improve-
ments households carry out for themselves, and any unreported jobs and incomes in the economy.
Deducting nuisance outputs and adding the value of unreported and non-marketed incomes would
make GDP a more accurate measure of the economy’s production of goods and services.
Furthermore, high GDP and even high per capita GDP are not necessarily good measures of eco-
nomic well-being. The composition of that output also affects standards of living. Health care
services are likely to have different effects than military expenditures. The United Nations pre-
pares an annual Human Development Index (HDI) to provide a more comprehensive measure of
a country’s achievements. The HDI provides a summary measure based on life expectancy, adult
literacy, and real GDP per capita.
Table 4.6 shows HDIs for the top ten countries in 2015, according to the Human Development
Report, 2016. The second last and last columns in the table are of particular interest. The second
last column shows the HDI adjusted for national per capita GNP. The underlying argument is that
ranking national economic wellbeing simply by using per capita GNP would miss the importance
of life expectancy and education as indicators of standards of living. For example, Singapore and
the United States would rank highest by per capita GNP alone, but that ranking is reduced by lower
life expectancy and years of schooling. The last two columns in the table compare HDI rankings
in 2015 compared to 2014.
Conclusion 97
Table 4.6: Top ten countries based on the United Nations human development index
HDI Country HDI Life Expected Mean GNP/pop1 GNP/pop HDI
Rank Expectancy yrs yrs − HDI rank
(years) schooling schooling rank2
2015 2015 2015 2015 2015 2015 2014

1 Norway 0.949 81.7 17.7 12.7 67614 5 1
2 Australia 0.939 82.5 20.4 13.2 42822 19 3
2 Switzerland 0.939 83.1 16 13.4 56364 7 2
4 Germany 0.926 81.1 17.1 13.2 45000 13 4
5 Denmark 0.925 80.4 19.2 12.7 44519 13 6
5 Singapore 0.925 83.2 15.4 11.6 78162 -3 4
7 Netherlands 0.924 81.7 18.1 11.9 46326 8 6
8 Ireland 0.923 81.1 18.6 12.3 37065 11 8
9 Iceland 0.921 82.7 19 12.2 43798 20 9
10 Canada 0.920 82.2 16.3 13.1 42582 12 9
10 United 0.920 79.2 16.5 13.2 53245 1 11
States
Source: United Nations Human Development Reports: 2016 HDR Report.
http://hdr.undp.org/en/composite/HDI
1
Note : GNP in PPP international dollars.
Note2 : Difference between rank by GNP per capita and by HDI value.
A negative value means the country is better ranked by GDP than HDI.
Do the limitations of GDP matter for our study of macroeconomics? Probably not. We will be
examining changes in real GDP from year to year, for the most part. As long as the importance
of nuisance and non-marketed outputs, life expectancy, literacy and inequalities do not change
dramatically in that time frame, changes in measured real GDP will provide good measures of
changes in economic activity and performance. Changes in per capita real GDP will also provide
measures of changes in standards of living.
C ONCLUSION
In this chapter we have looked at indicators of macroeconomic activity and performance, and
the measurement of macroeconomic activity using the national accounts. We have not examined
the conditions that determine the level of economic activity and fluctuations in that level. An
economic model is required for that work. In the next chapter we introduce the framework of a
basic macroeconomic model.
K EY C ONCEPTS
Macroeconomics studies the whole national economy as a system. It examines expenditure
decisions by households, businesses, and governments, and the total flows of goods and ser-
vices produced and incomes earned.
Real Gross Domestic Product (GDP), prices and inflation rates, and employment and un-
employment rates are indicators of macroeconomic activity and performance.
Fluctuations in the growth rate of real GDP, in inflation rates, and in unemployment rates are
important aspects of recent economic performance in Canada.
The expenditures by households, production of goods and services by business, and the in-
comes that result are illustrated by the circular flow of real resources and money payments.
The National Accounts provide a framework for the measurement of the output of the econ-
omy and the incomes earned in the economy.
Nominal GDP measures the output of final goods and services at market prices in the econ-
omy, and the money incomes earned by the factors of production.
Real GDP measures the output of final goods and services produced, and incomes earned at
constant prices.
The GDP deflator is a measure of the price level for all final goods and services in the econ-
omy.
Real GDP and per capita real GDP are crude measures of national and individual welfare.
They ignore non-market activities, the composition of output, and the distribution of income
among industries and households.
Exercises for Chapter 4 99
E XERCISES FOR C HAPTER 4

Exercise 4.1 You have the following annual data for an economy:
Year Real GDP Consumer price Labour force Employment

(2007 $) index (2007=100) (000) (000)
2012 1,282 109.1 17.593 16.537
2013 1,307 111.9 17.857 16.696
2014 1,288 138.9 18.125 16.856
(a) What was the rate of growth of real GDP from 2012 to 2013, and 2013 to 2014?
(b) What was the rate of inflation in 2013 and in 2014?
(c) What were the rates of growth of the labour force and employment from 2012 to 2013, and
2013 to 2014?
(d) What happened to the unemployment rate between 2012 and 2013, and between 2013 and
2014?
Exercise 4.2 Suppose the economy represented by the table in Exercise 4.1 above had a population
of 27.885 thousand in 2014.
(a) What were the participation and employment rates in the economy in that year?
(b) Suppose a mild recession in that year discouraged some unemployed workers and they stop
looking for work. As a result the participation rate fell to 64.5 per cent. How would the
unemployment rate and the employment rate be affected? Why?
Exercise 4.3 If brewers buy barley and hops from agricultural producers, natural gas to fire their
brew kettles from gas companies and bottles from glass manufacturers as in the following table,
what is the value added of the brewing industry? If brewers also wholesale some of their output to
pubs, is that output counted in GDP? Explain your answer.
Costs (millions of current $) of:

Brewery retail sales Barley and hops Natural gas Bottles
1000 350 125 150
Exercise 4.4 The economy has two main industries. One produces services and the other produces
goods. The services industries produce services for households and businesses with a total market
value of $10,000. The goods industries produce goods for the use of both households and busi-
nesses with a total market value of $5,000. The service industries spend $1,000 on computers and
paper and envelopes supplied by the goods industries. The goods industries spend $1,000 to buy
financial, insurance, advertising and custodial services supplied by the service industries. Explain
how you measure nominal GDP in this economy and the value of output you find?
Exercise 4.5 Suppose you are given the following data on incomes and expenditures for the econ-
omy of Westland, in current prices for factors of production and outputs.
Consumption expenditures 2,500

Employment compensation 2,800
Government expenditure 800
Net indirect taxes 150
Exports 1,200
Gross corporate surplus and mixed income 1,050
Investment expenditure 600
Imports 1,100
(a) What is the value of nominal GDP measured by expenditures?

(b) What is net domestic income?
(c) What is the value of nominal GDP measured by the income approach?
Exercise 4.6 Suppose GDP is $2,000, consumption expenditure is $1,700, government expenditure
is $50, and net exports are $40.
(a) What is business investment expenditure?

(b) If exports are $350, what are imports?
(c) In this example, net exports are positive. Could they be negative?
Exercise 4.7 Consider the following information about a hypothetical economy:
Year Nominal GDP GDP deflator Population

(billions $) (2000 = 100) (millions $)
2012 750 104.0 25.0
2013 825 112.0 30.0
(a) Calculate the growth (percentage change) in nominal GDP from 2012 to 2013.
Exercises for Chapter 4 101
(b) What was real GDP in 2012 and 2013? How much did real GDP grow?
(c) If changes in the standard of living can be measured by changes in real per capita GDP, did
growth in nominal and real GDP raise the standard of living in this economy from 2012 to
2013?
(d) Explain the reasons for the change in standard of living that you have found.
Chapter 6 | The Macroeconomic Perspective 133
6 | The Macroeconomic
Perspective
Figure 6.1 The Great Depression At times, such as when many people having trouble making ends meet, it is easy
to tell how the economy is doing. This photograph shows people lined up during the Great Depression, waiting for
relief checks. At other times, when some are doing well and others are not, it is more difficult to ascertain how the
economy of a country is doing. (Credit: modification of work by the U.S. Library of Congress/Wikimedia Commons)
How is the Economy Doing? How Does One Tell?

The 1990s were boom years for the U.S. economy. Beginning in the late 2000s, from 2007 to 2014 economic
performance in in the U.S. was poor. What causes the economy to expand or contract? Why do businesses
fail when they are making all the right decisions? Why do workers lose their jobs when they are hardworking
and productive? Are bad economic times a failure of the market system? Are they a failure of the government?
These are all questions of macroeconomics, which we will begin to address in this chapter. We will not be able
to answer all of these questions here, but we will start with the basics: How is the economy doing? How can
we tell?
The macro economy includes all buying and selling, all production and consumption; everything that goes
on in every market in the economy. How can we get a handle on that? The answer begins more than 80
years ago, during the Great Depression. President Franklin D. Roosevelt and his economic advisers knew
things were bad—but how could they express and measure just how bad it was? An economist named Simon
Kuznets, who later won the Nobel Prize for his work, came up with a way to track what the entire economy is
producing. In this chapter, you will learn how the government constructs GDP, how we use it, and why it is so
important.
134 Chapter 6 | The Macroeconomic Perspective
Introduction to the Macroeconomic Perspective

In this chapter, you will learn about:
• Measuring the Size of the Economy: Gross Domestic Product
• Adjusting Nominal Values to Real Values
• Tracking Real GDP over Time
• Comparing GDP among Countries
• How Well GDP Measures the Well-Being of Society
Macroeconomics focuses on the economy as a whole (or on whole economies as they interact). What causes
recessions? What makes unemployment stay high when recessions are supposed to be over? Why do some countries
grow faster than others? Why do some countries have higher standards of living than others? These are all questions
that macroeconomics addresses. Macroeconomics involves adding up the economic activity of all households and
all businesses in all markets to obtain the overall demand and supply in the economy. However, when we do
that, something curious happens. It is not unusual that what results at the macro level is different from the sum
of the microeconomic parts. What seems sensible from a microeconomic point of view can have unexpected or
counterproductive results at the macroeconomic level. Imagine that you are sitting at an event with a large audience,
like a live concert or a basketball game. A few people decide that they want a better view, and so they stand up.
However, when these people stand up, they block the view for other people, and the others need to stand up as well if
they wish to see. Eventually, nearly everyone is standing up, and as a result, no one can see much better than before.
The rational decision of some individuals at the micro level—to stand up for a better view—ended up as self-defeating
at the macro level. This is not macroeconomics, but it is an apt analogy.
Macroeconomics is a rather massive subject. How are we going to tackle it? Figure 6.2 illustrates the structure we
will use. We will study macroeconomics from three different perspectives:
1. What are the macroeconomic goals? (Macroeconomics as a discipline does not have goals, but we do have
goals for the macro economy.)
2. What are the frameworks economists can use to analyze the macroeconomy?
3. Finally, what are the policy tools governments can use to manage the macroeconomy?
Figure 6.2 Macroeconomic Goals, Framework, and Policies This chart shows what macroeconomics is about.
The box on the left indicates a consensus of what are the most important goals for the macro economy, the middle
box lists the frameworks economists use to analyze macroeconomic changes (such as inflation or recession), and the
box on the right indicates the two tools the federal government uses to influence the macro economy.
Goals
In thinking about the macroeconomy's overall health, it is useful to consider three primary goals: economic growth,
low unemployment, and low inflation.
• Economic growth ultimately determines the prevailing standard of living in a country. Economists measure
growth by the percentage change in real (inflation-adjusted) gross domestic product. A growth rate of more
than 3% is considered good.
• Unemployment, as measured by the unemployment rate, is the percentage of people in the labor force who
do not have a job. When people lack jobs, the economy is wasting a precious resource-labor, and the result is
This OpenStax book is available for free at http://cnx.org/content/col12190/1.4

lower goods and services produced. Unemployment, however, is more than a statistic—it represents people’s
livelihoods. While measured unemployment is unlikely to ever be zero, economists consider a measured
unemployment rate of 5% or less low (good).
• Inflation is a sustained increase in the overall level of prices, and is measured by the consumer price index. If
many people face a situation where the prices that they pay for food, shelter, and healthcare are rising much
faster than the wages they receive for their labor, there will be widespread unhappiness as their standard of
living declines. For that reason, low inflation—an inflation rate of 1–2%—is a major goal.
Frameworks
As you learn in the micro part of this book, principal tools that economists use are theories and models (see
Welcome to Economics! for more on this). In microeconomics, we used the theories of supply and demand. In
macroeconomics, we use the theories of aggregate demand (AD) and aggregate supply (AS). This book presents two
perspectives on macroeconomics: the Neoclassical perspective and the Keynesian perspective, each of which has its
own version of AD and AS. Between the two perspectives, you will obtain a good understanding of what drives the
macroeconomy.
Policy Tools
National governments have two tools for influencing the macroeconomy. The first is monetary policy, which involves
managing the money supply and interest rates. The second is fiscal policy, which involves changes in government
spending/purchases and taxes.
We will explain each of the items in Figure 6.2 in detail in one or more other chapters. As you learn these things,
you will discover that the goals and the policy tools are in the news almost every day.
6.1 | Measuring the Size of the Economy: Gross Domestic

Product
By the end of this section, you will be able to:
• Identify the components of GDP on the demand side and on the supply side
• Evaluate how economists measure gross domestic product (GDP)
• Contrast and calculate GDP, net exports, and net national product
Macroeconomics is an empirical subject, so the first step toward understanding it is to measure the economy.
How large is the U.S. economy? Economists typically measure the size of a nation’s overall economy by its gross
domestic product (GDP), which is the value of all final goods and services produced within a country in a given
year. Measuring GDP involves counting the production of millions of different goods and services—smart phones,
cars, music downloads, computers, steel, bananas, college educations, and all other new goods and services that a
country produced in the current year—and summing them into a total dollar value. This task is straightforward: take
the quantity of everything produced, multiply it by the price at which each product sold, and add up the total. In 2016,
the U.S. GDP totaled $18.6 trillion, the largest GDP in the world.
Each of the market transactions that enter into GDP must involve both a buyer and a seller. We can measure an
economy's GDP either by the total dollar value of what consumers purchase in the economy, or by the total dollar
value of what is the country produces. There is even a third way, as we will explain later.
GDP Measured by Components of Demand
Who buys all of this production? We can divide this demand into four main parts: consumer spending (consumption),
business spending (investment), government spending on goods and services, and spending on net exports. (See
the following Clear It Up feature to understand what we mean by investment.) Table 6.1 shows how these four
components added up to the GDP in 2016. Figure 6.4 (a) shows the levels of consumption, investment, and
government purchases over time, expressed as a percentage of GDP, while Figure 6.4 (b) shows the levels of exports
and imports as a percentage of GDP over time. A few patterns about each of these components are worth noticing.
Table 6.1 shows the components of GDP from the demand side.
Components of GDP on the Demand Side (in trillions of Percentage of

dollars) Total
Consumption $12.8 68.8%
Investment $3.0 16.1%
Government $3.3 17.7%
Exports $2.2 11.8%
Imports –$2.7 –14.5%
Total GDP $18.6 100%
Table 6.1 Components of U.S. GDP in 2016: From the Demand Side (Source: http://bea.gov/iTable/
index_nipa.cfm)
Figure 6.3 Percentage of Components of U.S. GDP on the Demand Side Consumption makes up over half of the
demand side components of the GDP. (Source: http://bea.gov/iTable/index_nipa.cfm)
What does the word “investment” mean?

What do economists mean by investment, or business spending? In calculating GDP, investment does not
refer to purchasing stocks and bonds or trading financial assets. It refers to purchasing new capital goods, that
is, new commercial real estate (such as buildings, factories, and stores) and equipment, residential housing
construction, and inventories. Inventories that manufacturers produce this year are included in this year’s
GDP—even if they are not yet sold. From the accountant’s perspective, it is as if the firm invested in its own
inventories. Business investment in 2016 was $3 trillion, according to the Bureau of Economic Analysis.

Figure 6.4 Components of GDP on the Demand Side (a) Consumption is about two-thirds of GDP, and it has
been on a slight upward trend over time. Business investment hovers around 15% of GDP, but it fluctuates more than
consumption. Government spending on goods and services is slightly under 20% of GDP and has declined modestly
over time. (b) Exports are added to total demand for goods and services, while imports are subtracted from total
demand. If exports exceed imports, as in most of the 1960s and 1970s in the U.S. economy, a trade surplus exists. If
imports exceed exports, as in recent years, then a trade deficit exists. (Source: http://bea.gov/iTable/index_nipa.cfm)
Consumption expenditure by households is the largest component of GDP, accounting for about two-thirds of the
GDP in any year. This tells us that consumers’ spending decisions are a major driver of the economy. However,
consumer spending is a gentle elephant: when viewed over time, it does not jump around too much, and has increased
modestly from about 60% of GDP in the 1960s and 1970s.
Investment expenditure refers to purchases of physical plant and equipment, primarily by businesses. If Starbucks
builds a new store, or Amazon buys robots, they count these expenditures under business investment. Investment
demand is far smaller than consumption demand, typically accounting for only about 15–18% of GDP, but it is
very important for the economy because this is where jobs are created. However, it fluctuates more noticeably than
consumption. Business investment is volatile. New technology or a new product can spur business investment, but
then confidence can drop and business investment can pull back sharply.
If you have noticed any of the infrastructure projects (new bridges, highways, airports) launched during the 2009
recession, you have seen how important government spending can be for the economy. Government expenditure in
the United States is close to 20% of GDP, and includes spending by all three levels of government: federal, state,
and local. The only part of government spending counted in demand is government purchases of goods or services
produced in the economy. Examples include the government buying a new fighter jet for the Air Force (federal
government spending), building a new highway (state government spending), or a new school (local government
spending). A significant portion of government budgets consists of transfer payments, like unemployment benefits,
veteran’s benefits, and Social Security payments to retirees. The government excludes these payments from GDP
because it does not receive a new good or service in return or exchange. Instead they are transfers of income from
taxpayers to others. If you are curious about the awesome undertaking of adding up GDP, read the following Clear It
Up feature.
How do statisticians measure GDP?

Government economists at the Bureau of Economic Analysis (BEA), within the U.S. Department of
Commerce, piece together estimates of GDP from a variety of sources.
Once every five years, in the second and seventh year of each decade, the Bureau of the Census carries
out a detailed census of businesses throughout the United States. In between, the Census Bureau carries
out a monthly survey of retail sales. The government adjusts these figures with foreign trade data to account
for exports that are produced in the United States and sold abroad and for imports that are produced abroad
and sold here. Once every ten years, the Census Bureau conducts a comprehensive survey of housing
and residential finance. Together, these sources provide the main basis for figuring out what is produced for
consumers.
For investment, the Census Bureau carries out a monthly survey of construction and an annual survey of
expenditures on physical capital equipment.
For what the federal government purchases, the statisticians rely on the U.S. Department of the Treasury. An
annual Census of Governments gathers information on state and local governments. Because the government
spends a considerable amount at all levels hiring people to provide services, it also tracks a large portion of
spending through payroll records that state governments and the Social Security Administration collect.
With regard to foreign trade, the Census Bureau compiles a monthly record of all import and export
documents. Additional surveys cover transportation and travel, and make adjustments for financial services
that are produced in the United States for foreign customers.
Many other sources contribute to GDP estimates. Information on energy comes from the U.S. Department
of Transportation and Department of Energy. The Agency for Health Care Research and Quality collects
information on healthcare. Surveys of landlords find out about rental income. The Department of Agriculture
collects statistics on farming.
All these bits and pieces of information arrive in different forms, at different time intervals. The BEA melds
them together to produce GDP estimates on a quarterly basis (every three months). The BEA then
"annualizes" these numbers by multiplying by four. As more information comes in, the BEA updates and
revises these estimates. BEA releases the GDP “advance” estimate for a certain quarter one month after a
quarter. The “preliminary” estimate comes out one month after that. The BEA publishes the “final” estimate
one month later, but it is not actually final. In July, the BEA releases roughly updated estimates for the previous
calendar year. Then, once every five years, after it has processed all the results of the latest detailed five-year
business census, the BEA revises all of the past GDP estimates according to the newest methods and data,
going all the way back to 1929.
Visit this website (http://openstaxcollege.org/l/beafaq) to read FAQs on the BEA site. You can even email your
own questions!
When thinking about the demand for domestically produced goods in a global economy, it is important to count
spending on exports—domestically produced goods that a country sells abroad. Similarly, we must also subtract
spending on imports—goods that a country produces in other countries that residents of this country purchase. The
GDP net export component is equal to the dollar value of exports (X) minus the dollar value of imports (M), (X –
M). We call the gap between exports and imports the trade balance. If a country’s exports are larger than its imports,
then a country has a trade surplus. In the United States, exports typically exceeded imports in the 1960s and 1970s,
as Figure 6.4(b) shows.
Since the early 1980s, imports have typically exceeded exports, and so the United States has experienced a trade

deficit in most years. The trade deficit grew quite large in the late 1990s and in the mid-2000s. Figure 6.4 (b) also
shows that imports and exports have both risen substantially in recent decades, even after the declines during the Great
Recession between 2008 and 2009. As we noted before, if exports and imports are equal, foreign trade has no effect on
total GDP. However, even if exports and imports are balanced overall, foreign trade might still have powerful effects
on particular industries and workers by causing nations to shift workers and physical capital investment toward one
industry rather than another.
Based on these four components of demand, we can measure GDP as:
GDP = Consumption + Investment + Government + Trade balance
GDP = C + I + G + (X – M)
Understanding how to measure GDP is important for analyzing connections in the macro economy and for thinking
about macroeconomic policy tools.
GDP Measured by What is Produced
Everything that we purchase somebody must first produce. Table 6.2 breaks down what a country produces into five
categories: durable goods, nondurable goods, services, structures, and the change in inventories. Before going
into detail about these categories, notice that total GDP measured according to what is produced is exactly the same
as the GDP measured by looking at the five components of demand. Figure 6.5 provides a visual representation of
this information.
Components of GDP on the Supply Side (in trillions of Percentage of

dollars) Total
Goods
Durable goods $3.0 16.1%
Nondurable goods $2.5 13.4%
Services $11.6 62.4%
Structures $1.5 8.1%
Change in $0.0 0.0%

inventories
Total GDP $18.6 100%
Table 6.2 Components of U.S. GDP on the Production Side, 2016 (Source: http://bea.gov/iTable/
index_nipa.cfm)
Figure 6.5 Percentage of Components of GDP on the Production Side Services make up over 60 percent of the
production side components of GDP in the United States.
Since every market transaction must have both a buyer and a seller, GDP must be the same whether measured by
what is demanded or by what is produced. Figure 6.6 shows these components of what is produced, expressed as a
percentage of GDP, since 1960.

Figure 6.6 Types of Production Services are the largest single component of total supply, representing over 60
percent of GDP, up from about 45 perent in the early 1960s. Durable and nondurable goods constitute the
manufacturing sector, and they have declined from 45 percent of GDP in 1960 to about 30 percent in 2016.
Nondurable goods used to be larger than durable goods, but in recent years, nondurable goods have been dropping
to below the share of durable goods, which is less than 20% of GDP. Structures hover around 10% of GDP. We do
not show here the change in inventories, the final component of aggregate supply. It is typically less than 1% of GDP.
In thinking about what is produced in the economy, many non-economists immediately focus on solid, long-lasting
goods, like cars and computers. By far the largest part of GDP, however, is services. Moreover, services have been a
growing share of GDP over time. A detailed breakdown of the leading service industries would include healthcare,
education, and legal and financial services. It has been decades since most of the U.S. economy involved making
solid objects. Instead, the most common jobs in a modern economy involve a worker looking at pieces of paper or a
computer screen; meeting with co-workers, customers, or suppliers; or making phone calls.
Even within the overall category of goods, long-lasting durable goods like cars and refrigerators are about the same
share of the economy as short-lived nondurable goods like food and clothing. The category of structures includes
everything from homes, to office buildings, shopping malls, and factories. Inventories is a small category that refers
to the goods that one business has produced but has not yet sold to consumers, and are still sitting in warehouses and
on shelves. The amount of inventories sitting on shelves tends to decline if business is better than expected, or to rise
if business is worse than expected.
Another Way to Measure GDP: The National Income Approach
GDP is a measure of what is produced in a nation. The primary way GDP is estimated is with the Expenditure
Approach we discussed above, but there is another way. Everything a firm produces, when sold, becomes revenues
to the firm. Businesses use revenues to pay their bills: Wages and salaries for labor, interest and dividends for capital,
rent for land, profit to the entrepreneur, etc. So adding up all the income produced in a year provides a second way
of measuring GDP. This is why the terms GDP and national income are sometimes used interchangeably. The total
value of a nation’s output is equal to the total value of a nation’s income.
The Problem of Double Counting

We define GDP as the current value of all final goods and services produced in a nation in a year. What are final
goods? They are goods at the furthest stage of production at the end of a year. Statisticians who calculate GDP must
avoid the mistake of double counting, in which they count output more than once as it travels through the production
stages. For example, imagine what would happen if government statisticians first counted the value of tires that a tire
manufacturer produces, and then counted the value of a new truck that an automaker sold that contains those tires. In
this example, the statisticians would have counted the value of the tires twice-because the truck's price includes the
value of the tires.
To avoid this problem, which would overstate the size of the economy considerably, government statisticians count
just the value of final goods and services in the chain of production that are sold for consumption, investment,
government, and trade purposes. Statisticians exclude intermediate intermediate goods, which are goods that go into
producing other goods, from GDP calculations. From the example above, they will only count the Ford truck's value.
The value of what businesses provide to other businesses is captured in the final products at the end of the production
chain.
The concept of GDP is fairly straightforward: it is just the dollar value of all final goods and services produced in
the economy in a year. In our decentralized, market-oriented economy, actually calculating the more than $18 trillion-
dollar U.S. GDP—along with how it is changing every few months—is a full-time job for a brigade of government
statisticians.
What is Counted in GDP What is not included in GDP
Consumption Intermediate goods
Business investment Transfer payments and non-market activities
Government spending on goods and services Used goods
Net exports Illegal goods
Table 6.3 Counting GDP
Notice the items that are not counted into GDP, as Table 6.3 outlines. The sales of used goods are not included
because they were produced in a previous year and are part of that year’s GDP. The entire underground economy
of services paid “under the table” and illegal sales should be counted, but is not, because it is impossible to track
these sales. In Friedrich Schneider's recent study of shadow economies, he estimated the underground economy in the
United States to be 6.6% of GDP, or close to $2 trillion dollars in 2013 alone. Transfer payments, such as payment by
the government to individuals, are not included, because they do not represent production. Also, production of some
goods—such as home production as when you make your breakfast—is not counted because these goods are not sold
in the marketplace.
Visit this website (http://openstaxcollege.org/l/undergroundecon) to read about the “New Underground

Economy.”

Other Ways to Measure the Economy

Besides GDP, there are several different but closely related ways of measuring the size of the economy. We mentioned
above that we can think of GDP as total production and as total purchases. We can also think of it as total income
since anything one produces and sells yields income.
One of the closest cousins of GDP is the gross national product (GNP). GDP includes only what country produces
within its borders. GNP adds what domestic businesses and labor abroad produces, and subtracts any payments that
foreign labor and businesses located in the United States send home to other countries. In other words, GNP is based
more on what a country's citizens and firms produce, wherever they are located, and GDP is based on what happens
within a certain county's geographic boundaries. For the United States, the gap between GDP and GNP is relatively
small; in recent years, only about 0.2%. For small nations, which may have a substantial share of their population
working abroad and sending money back home, the difference can be substantial.
We calculate net national product (NNP) by taking GNP and then subtracting the value of how much physical
capital is worn out, or reduced in value because of aging, over the course of a year. The process by which capital
ages and loses value is called depreciation. We can further subdivide NNP into national income, which includes all
income to businesses and individuals, and personal income, which includes only income to people.
For practical purposes, it is not vital to memorize these definitions. However, it is important to be aware that these
differences exist and to know what statistic you are examining, so that you do not accidentally compare, say, GDP
in one year or for one country with GNP or NNP in another year or another country. To get an idea of how these
calculations work, follow the steps in the following Work It Out feature.
Calculating GDP, Net Exports, and NNP

Based on the information in Table 6.4:
a. What is the value of GDP?
b. What is the value of net exports?
c. What is the value of NNP?
Government purchases $120 billion
Depreciation $40 billion
Consumption $400 billion
Business Investment $60 billion
Exports $100 billion
Table 6.4
Imports $120 billion
Income receipts from rest of the world $10 billion
Income payments to rest of the world $8 billion
Table 6.4
Step 1. To calculate GDP use the following formula:

GDP = Consumption + Investment + Government spending + (Exports – Imports)
= C + I + G + (X – M)
= $400 + $60 + $120 + ($100 – $120)
= $560 billion
Step 2. To calculate net exports, subtract imports from exports.
Net exports = X – M
= $100 – $120
= –$20 billion
Step 3. To calculate NNP, use the following formula:
NNP = GDP + Income receipts from the rest of the world
– Income payments to the rest of the world – Depreciation
= $560 + $10 – $8 – $40
= $522 billion
6.2 | Adjusting Nominal Values to Real Values

• Contrast nominal GDP and real GDP
• Explain GDP deflator
• Calculate real GDP based on nominal GDP values
When examining economic statistics, there is a crucial distinction worth emphasizing. The distinction is between
nominal and real measurements, which refer to whether or not inflation has distorted a given statistic. Looking at
economic statistics without considering inflation is like looking through a pair of binoculars and trying to guess
how close something is: unless you know how strong the lenses are, you cannot guess the distance very accurately.
Similarly, if you do not know the inflation rate, it is difficult to figure out if a rise in GDP is due mainly to a rise in
the overall level of prices or to a rise in quantities of goods produced. The nominal value of any economic statistic
means that we measure the statistic in terms of actual prices that exist at the time. The real value refers to the same
statistic after it has been adjusted for inflation. Generally, it is the real value that is more important.
Converting Nominal to Real GDP
Table 6.5 shows U.S. GDP at five-year intervals since 1960 in nominal dollars; that is, GDP measured using the
actual market prices prevailing in each stated year. Figure 6.7 also reflects this data in a graph.

Year Nominal GDP (billions of dollars) GDP Deflator (2005 = 100)
1960 543.3 19.0
1965 743.7 20.3
1970 1,075.9 24.8
1975 1,688.9 34.1
1980 2,862.5 48.3
1985 4,346.7 62.3
1990 5,979.6 72.7
1995 7,664.0 81.7
2000 10,289.7 89.0
2005 13,095.4 100.0
2010 14,958.3 110.0
Table 6.5 U.S. Nominal GDP and the GDP Deflator (Source: www.bea.gov)
Figure 6.7 U.S. Nominal GDP, 1960–2010 Nominal GDP values have risen exponentially from 1960 through 2010,
according to the BEA.
If an unwary analyst compared nominal GDP in 1960 to nominal GDP in 2010, it might appear that national output
had risen by a factor of more than twenty-seven over this time (that is, GDP of $14,958 billion in 2010 divided by
GDP of $543 billion in 1960 = 27.5). This conclusion would be highly misleading. Recall that we define nominal
GDP as the quantity of every good or service produced multiplied by the price at which it was sold, summed up for
all goods and services. In order to see how much production has actually increased, we need to extract the effects of
higher prices on nominal GDP. We can easily accomplish this using the GDP deflator.
The GDP deflator is a price index measuring the average prices of all goods and services included in the economy.
We explore price indices in detail and how we compute them in Inflation, but this definition will do in the context of
this chapter. Table 6.5 provides the GDP deflator data and Figure 6.8 shows it graphically.
Figure 6.8 U.S. GDP Deflator, 1960–2010 Much like nominal GDP, the GDP deflator has risen exponentially from
1960 through 2010. (Source: BEA)
Figure 6.8 shows that the price level has risen dramatically since 1960. The price level in 2010 was almost six
times higher than in 1960 (the deflator for 2010 was 110 versus a level of 19 in 1960). Clearly, much of the growth
in nominal GDP was due to inflation, not an actual change in the quantity of goods and services produced, in other
words, not in real GDP. Recall that nominal GDP can rise for two reasons: an increase in output, and/or an increase in
prices. What is needed is to extract the increase in prices from nominal GDP so as to measure only changes in output.
After all, the dollars used to measure nominal GDP in 1960 are worth more than the inflated dollars of 1990—and the
price index tells exactly how much more. This adjustment is easy to do if you understand that nominal measurements
are in value terms, where
Value = Price × Quantity
or
Nominal GDP = GDP Defla or × Real GDP
Let’s look at an example at the micro level. Suppose the t-shirt company, Coolshirts, sells 10 t-shirts at a price of $9
each.
Coolshirt's nominal revenue from sales = Price × Quantity
= $9 × 10
= $90
Then,
Coolshirt's real income = Nominal revenue

Price
= $90
$9
= 10
In other words, when we compute “real” measurements we are trying to obtain actual quantities, in this case, 10 t-
shirts.
With GDP, it is just a tiny bit more complicated. We start with the same formula as above:
Real GDP = Nominal GDP

Price Index
For reasons that we will explain in more detail below, mathematically, a price index is a two-digit decimal number like
1.00 or 0.85 or 1.25. Because some people have trouble working with decimals, when the price index is published, it
has traditionally been multiplied by 100 to get integer numbers like 100, 85, or 125. What this means is that when we
“deflate” nominal figures to get real figures (by dividing the nominal by the price index). We also need to remember
to divide the published price index by 100 to make the math work. Thus, the formula becomes:


Price Index / 100
Now read the following Work It Out feature for more practice calculating real GDP.
Computing GDP
It is possible to use the data in Table 6.5 to compute real GDP.
Step 1. Look at Table 6.5, to see that, in 1960, nominal GDP was $543.3 billion and the price index (GDP
deflator) was 19.0.
Step 2. To calculate the real GDP in 1960, use the formula:

Price Index / 100
= $543.3 billion
19 / 100
= $2,859.5 billion
We’ll do this in two parts to make it clear. First adjust the price index: 19 divided by 100 = 0.19. Then divide
into nominal GDP: $543.3 billion / 0.19 = $2,859.5 billion.
Step 3. Use the same formula to calculate the real GDP in 1965.

Price Index / 100
= $743.7 billion
20.3 / 100
= $3,663.5 billion
Step 4. Continue using this formula to calculate all of the real GDP values from 1960 through 2010. The
calculations and the results are in Table 6.6.
Nominal GDP GDP Deflator Real GDP (billions of

Year Calculations
(billions of dollars) (2005 = 100) 2005 dollars)
1960 543.3 19.0 543.3 / 2859.5

(19.0/100)
1965 743.7 20.3 743.7 / 3663.5

(20.3/100)
1970 1075.9 24.8 1,075.9 / 4338.3

(24.8/100)
1975 1688.9 34.1 1,688.9 / 4952.8

(34.1/100)
1980 2862.5 48.3 2,862.5 / 5926.5

(48.3/100)
1985 4346.7 62.3 4,346.7 / 6977.0

(62.3/100)
1990 5979.6 72.7 5,979.6 / 8225.0

(72.7/100)
Table 6.6 Converting Nominal to Real GDP (Source: Bureau of Economic Analysis,
www.bea.gov)

Nominal GDP GDP Deflator Real GDP (billions of

Year Calculations
(billions of dollars) (2005 = 100) 2005 dollars)
1995 7664.0 82.0 7,664 / 9346.3

(82.0/100)
2000 10289.7 89.0 10,289.7 / 11561.5

(89.0/100)
2005 13095.4 100.0 13,095.4 / 13095.4

(100.0/100)
2010 14958.3 110.0 14,958.3 / 13598.5

(110.0/100)
Table 6.6 Converting Nominal to Real GDP (Source: Bureau of Economic Analysis,
www.bea.gov)
There are a couple things to notice here. Whenever you compute a real statistic, one year (or period) plays
a special role. It is called the base year (or base period). The base year is the year whose prices we use
to compute the real statistic. When we calculate real GDP, for example, we take the quantities of goods and
services produced in each year (for example, 1960 or 1973) and multiply them by their prices in the base year
(in this case, 2005), so we get a measure of GDP that uses prices that do not change from year to year. That
is why real GDP is labeled “Constant Dollars” or, in this example, “2005 Dollars,” which means that real GDP
is constructed using prices that existed in 2005. While the example here uses 2005 as the base year, more
generally, you can use any year as the base year. The formula is:
GDP defla or = Nominal GDP × 100

Real GDP
Rearranging the formula and using the data from 2005:

Price Index / 100
= $13,095.4 billion
100 / 100
= $13,095.4 billion
Comparing real GDP and nominal GDP for 2005, you see they are the same. This is no accident. It is because
we have chosen 2005 as the “base year” in this example. Since the price index in the base year always has a
value of 100 (by definition), nominal and real GDP are always the same in the base year.
Look at the data for 2010.

Price Index / 100
= $14,958.3 billion
110 / 100
= $13,598.5 billion
Use this data to make another observation: As long as inflation is positive, meaning prices increase on
average from year to year, real GDP should be less than nominal GDP in any year after the base year. The
reason for this should be clear: The value of nominal GDP is “inflated” by inflation. Similarly, as long as inflation
is positive, real GDP should be greater than nominal GDP in any year before the base year.
Figure 6.9 shows the U.S. nominal and real GDP since 1960. Because 2005 is the base year, the nominal and real
values are exactly the same in that year. However, over time, the rise in nominal GDP looks much larger than the
rise in real GDP (that is, the nominal GDP line rises more steeply than the real GDP line), because the presence of
inflation, especially in the 1970s exaggerates the rise in nominal GDP.
Figure 6.9 U.S. Nominal and Real GDP, 1960–2012 The red line measures U.S. GDP in nominal dollars. The black
line measures U.S. GDP in real dollars, where all dollar values are converted to 2005 dollars. Since we express real
GDP in 2005 dollars, the two lines cross in 2005. However, real GDP will appear higher than nominal GDP in the
years before 2005, because dollars were worth less in 2005 than in previous years. Conversely, real GDP will appear
lower in the years after 2005, because dollars were worth more in 2005 than in later years.
Let’s return to the question that we posed originally: How much did GDP increase in real terms? What was the real
GDP growth rate from 1960 to 2010? To find the real growth rate, we apply the formula for percentage change:
2010 real GDP – 1960 real GDP × 100 = % change
1960 real GDP
13,598.5 – 2,859.5 × 100 = 376%
2,859.5
In other words, the U.S. economy has increased real production of goods and services by nearly a factor of four since
1960. Of course, that understates the material improvement since it fails to capture improvements in the quality of
products and the invention of new products.
There is a quicker way to answer this question approximately, using another math trick. Because:
Nominal = Price × Quantity
% change in Nominal = % change in Price + % change in Quantity
OR
% change in Quantity = % change in Nominal – % change in Price
Therefore, real GDP growth rate (% change in quantity) equals the growth rate in nominal GDP (% change in value)
minus the inflation rate (% change in price).
Note that using this equation provides an approximation for small changes in the levels. For more accurate measures,
one should use the first formula.
6.3 | Tracking Real GDP over Time

• Explain recessions, depressions, peaks, and troughs
• Evaluate the importance of tracking real GDP over time

When news reports indicate that “the economy grew 1.2% in the first quarter,” the reports are referring to the
percentage change in real GDP. By convention, governments report GDP growth is at an annualized rate: Whatever
the calculated growth in real GDP was for the quarter, we multiply it by four when it is reported as if the economy
were growing at that rate for a full year.
Figure 6.10 U.S. GDP, 1900–2016 Real GDP in the United States in 2016 (in 2009 dollars) was about $16.7 trillion.
After adjusting to remove the effects of inflation, this represents a roughly 20-fold increase in the economy’s
production of goods and services since the start of the twentieth century. (Source: bea.gov)
Figure 6.10 shows the pattern of U.S. real GDP since 1900. Short term declines have regularly interrupted the
generally upward long-term path of GDP. We call a significant decline in real GDP a recession. We call an especially
lengthy and deep recession a depression. The severe drop in GDP that occurred during the 1930s Great Depression
is clearly visible in the figure, as is the 2008–2009 Great Recession.
Real GDP is important because it is highly correlated with other measures of economic activity, like employment and
unemployment. When real GDP rises, so does employment.
The most significant human problem associated with recessions (and their larger, uglier cousins, depressions) is that a
slowdown in production means that firms need to lay off or fire some of their workers. Losing a job imposes painful
financial and personal costs on workers, and often on their extended families as well. In addition, even those who
keep their jobs are likely to find that wage raises are scanty at best—or their employers may ask them to take pay
cuts.
Table 6.7 lists the pattern of recessions and expansions in the U.S. economy since 1900. We call the highest point
of the economy, before the recession begins, the peak. Conversely, the lowest point of a recession, before a recovery
begins, is the trough. Thus, a recession lasts from peak to trough, and an economic upswing runs from trough to peak.
We call the economy's movement from peak to trough and trough to peak the business cycle. It is intriguing to notice
that the three longest trough-to-peak expansions of the twentieth century have happened since 1960. The most recent
recession started in December 2007 and ended formally in June 2009. This was the most severe recession since the
1930s Great Depression. The ongoing expansion since the June 2009 trough will also be quite long, comparatively,
having already reached 90 months at the end of 2016.
Trough Peak Months of Contraction Months of Expansion
December 1900 September 1902 18 21
August 1904 May 1907 23 33
June 1908 January 1910 13 19
January 1912 January 1913 24 12
December 1914 August 1918 23 44
March 1919 January 1920 7 10
July 1921 May 1923 18 22
July 1924 October 1926 14 27
Table 6.7 U.S. Business Cycles since 1900 (Source: http://www.nber.org/cycles/main.html)

Trough Peak Months of Contraction Months of Expansion
November 1927 August 1929 23 21
March 1933 May 1937 43 50
June 1938 February 1945 13 80
October 1945 November 1948 8 37
October 1949 July 1953 11 45
May 1954 August 1957 10 39
April 1958 April 1960 8 24
February 1961 December 1969 10 106
November 1970 November 1973 11 36
March 1975 January 1980 16 58
July 1980 July 1981 6 12
November 1982 July 1990 16 92
March 1991 March 2001 8 120
November 2001 December 2007 8 73
Table 6.7 U.S. Business Cycles since 1900 (Source: http://www.nber.org/cycles/main.html)
A private think tank, the National Bureau of Economic Research (NBER), tracks business cycles for the U.S.
economy. However, the effects of a severe recession often linger after the official ending date assigned by the NBER.
6.4 | Comparing GDP among Countries

• Explain how we can use GDP to compare the economic welfare of different nations
• Calculate the conversion of GDP to a common currency by using exchange rates
• Calculate GDP per capita using population data
It is common to use GDP as a measure of economic welfare or standard of living in a nation. When comparing the
GDP of different nations for this purpose, two issues immediately arise. First, we measure a country's GDP in its own
currency: the United States uses the U.S. dollar; Canada, the Canadian dollar; most countries of Western Europe, the
euro; Japan, the yen; Mexico, the peso; and so on. Thus, comparing GDP between two countries requires converting
to a common currency. A second issue is that countries have very different numbers of people. For instance, the
United States has a much larger economy than Mexico or Canada, but it also has almost three times as many people
as Mexico and nine times as many people as Canada. Thus, if we are trying to compare standards of living across
countries, we need to divide GDP by population.
Converting Currencies with Exchange Rates
To compare the GDP of countries with different currencies, it is necessary to convert to a “common denominator”
using an exchange rate, which is the value of one currency in terms of another currency. We express exchange
rates either as the units of country A’s currency that need to be traded for a single unit of country B’s currency
(for example, Japanese yen per British pound), or as the inverse (for example, British pounds per Japanese yen).
We can use two types of exchange rates for this purpose, market exchange rates and purchasing power parity (PPP)

equivalent exchange rates. Market exchange rates vary on a day-to-day basis depending on supply and demand in
foreign exchange markets. PPP-equivalent exchange rates provide a longer run measure of the exchange rate. For this
reason, economists typically use PPP-equivalent exchange rates for GDP cross country comparisons. We will discuss
exchange rates in more detail in Exchange Rates and International Capital Flows. The following Work It Out
feature explains how to convert GDP to a common currency.
Converting GDP to a Common Currency

Using the exchange rate to convert GDP from one currency to another is straightforward. Say that the task is
to compare Brazil’s GDP in 2013 of 4.8 trillion reals with the U.S. GDP of $16.6 trillion for the same year.
Step 1. Determine the exchange rate for the specified year. In 2013, the exchange rate was 2.230 reals = $1.
(These numbers are realistic, but rounded off to simplify the calculations.)
Step 2. Convert Brazil’s GDP into U.S. dollars:
Brazil's GDP in $ U.S. = Brazil's GDP in reals

Exchange rate (reals/$ U.S.)
= 4.8 trillion reals
2.230 reals per $ U.S.
= $2.2 trillion
Step 3. Compare this value to the GDP in the United States in the same year. The U.S. GDP was $16.6 trillion
in 2013, which is nearly eight times that of GDP in Brazil in 2012.
Step 4. View Table 6.8 which shows the size of and variety of GDPs of different countries in 2013, all
expressed in U.S. dollars. We calculate each using the process that we explained above.
GDP in Billions of Domestic Currency/U.S. GDP (in billions

Country
Domestic Currency Dollars (PPP Equivalent) of U.S. dollars)
Brazil 4,844.80 reals 2.157 2,246.00
Canada 1,881.20 dollars 1.030 1,826.80
China 58,667.30 yuan 6.196 9,469.10
Egypt 1,753.30 pounds 6.460 271.40
Germany 2,737.60 euros 0.753 3,636.00
India 113,550.70 rupees 60.502 1,876.80
Japan 478,075.30 yen 97.596 4,898.50
Mexico 16,104.40 pesos 12.772 1,260.90
South 1,428,294.70 won 1,094.925 1,304.467

Korea
United 1,612.80 pounds 0.639 2,523.20

Kingdom
Table 6.8 Comparing GDPs Across Countries, 2013 (Source: http://www.imf.org/external/

pubs/ft/weo/2013/01/weodata/index.aspx)
GDP in Billions of Domestic Currency/U.S. GDP (in billions

Country
Domestic Currency Dollars (PPP Equivalent) of U.S. dollars)
United 16,768.10 dollars 1.000 16,768.10

States
Table 6.8 Comparing GDPs Across Countries, 2013 (Source: http://www.imf.org/external/

pubs/ft/weo/2013/01/weodata/index.aspx)
GDP Per Capita

The U.S. economy has the largest GDP in the world, by a considerable amount. The United States is also a populous
country; in fact, it is the third largest country by population in the world, although well behind China and India. Is the
U.S. economy larger than other countries just because the United States has more people than most other countries,
or because the U.S. economy is actually larger on a per-person basis? We can answer this question by calculating a
country’s GDP per capita; that is, the GDP divided by the population.
GDP per capita = GDP/population
The second column of Table 6.9 lists the GDP of the same selection of countries that appeared in the previous
Tracking Real GDP over Time and Table 6.8, showing their GDP as converted into U.S. dollars (which is the
same as the last column of the previous table). The third column gives the population for each country. The fourth
column lists the GDP per capita. We obtain GDP per capita in two steps: First, by multiplying column two (GDP, in
billions of dollars) by 1000 so it has the same units as column three (Population, in millions). Then divide the result
(GDP in millions of dollars) by column three (Population, in millions).
GDP (in billions of U.S. Population (in Per Capita GDP (in U.S.
Country
dollars) millions) dollars)
Brazil 2,246.00 199.20 11,275.10
Canada 1,826.80 35.10 52,045.58
China 9,469.10 1,360.80 6,958.48
Egypt 271.40 83.70 3,242.90
Germany 3,636.00 80.80 44,999.50
India 1,876.80 1,243.30 1,509.50
Japan 4,898.50 127.3 38,479.97
Mexico 1,260.90 118.40 10,649.90
South Korea 1,304.47 50.20 25,985.46
United 2,523.20 64.10 39,363.50

Kingdom
United 16,768.10 316.30 53,013.28

States
Table 6.9 GDP Per Capita, 2013 (Source: http://www.imf.org/external/pubs/ft/weo/2013/01/weodata/

index.aspx)

Notice that the ranking by GDP is different from the ranking by GDP per capita. India has a somewhat larger GDP
than Germany, but on a per capita basis, Germany has more than 10 times India’s standard of living. Will China soon
have a better standard of living than the U.S.? Read the following Clear It Up feature to find out.
Is China going to surpass the United States in terms of standard

of living?
As Table 6.9 shows, China has the second largest GDP of the countries: $9.5 trillion compared to the United
States’ $16.8 trillion. Perhaps it will surpass the United States, but probably not any time soon. China has
a much larger population so that in per capita terms, its GDP is less than one fifth that of the United States
($6,958.48 compared to $53,013). The Chinese people are still quite poor relative to the United States and
other developed countries. One caveat: For reasons we will discuss shortly, GDP per capita can give us only
a rough idea of the differences in living standards across countries.
The world's high-income nations—including the United States, Canada, the Western European countries, and
Japan—typically have GDP per capita in the range of $20,000 to $50,000. Middle-income countries, which include
much of Latin America, Eastern Europe, and some countries in East Asia, have GDP per capita in the range of $6,000
to $12,000. The world's low-income countries, many of them located in Africa and Asia, often have GDP per capita
of less than $2,000 per year.
6.5 | How Well GDP Measures the Well-Being of Society

• Discuss how productivity influences the standard of living
• Explain the limitations of GDP as a measure of the standard of living
• Analyze the relationship between GDP data and fluctuations in the standard of living
The level of GDP per capita clearly captures some of what we mean by the phrase “standard of living.” Most of the
migration in the world, for example, involves people who are moving from countries with relatively low GDP per
capita to countries with relatively high GDP per capita.
“Standard of living” is a broader term than GDP. While GDP focuses on production that is bought and sold in markets,
standard of living includes all elements that affect people’s well-being, whether they are bought and sold in the
market or not. To illuminate the difference between GDP and standard of living, it is useful to spell out some things
that GDP does not cover that are clearly relevant to standard of living.
Limitations of GDP as a Measure of the Standard of Living
While GDP includes spending on recreation and travel, it does not cover leisure time. Clearly, however, there is a
substantial difference between an economy that is large because people work long hours, and an economy that is just
as large because people are more productive with their time so they do not have to work as many hours. The GDP per
capita of the U.S. economy is larger than the GDP per capita of Germany, as Table 6.9 showed, but does that prove
that the standard of living in the United States is higher? Not necessarily, since it is also true that the average U.S.
worker works several hundred hours more per year more than the average German worker. Calculating GDP does not
account for the German worker’s extra vacation weeks.
While GDP includes what a country spends on environmental protection, healthcare, and education, it does not
include actual levels of environmental cleanliness, health, and learning. GDP includes the cost of buying pollution-
control equipment, but it does not address whether the air and water are actually cleaner or dirtier. GDP includes
spending on medical care, but does not address whether life expectancy or infant mortality have risen or fallen.
Similarly, it counts spending on education, but does not address directly how much of the population can read, write,
or do basic mathematics.
GDP includes production that is exchanged in the market, but it does not cover production that is not exchanged in
the market. For example, hiring someone to mow your lawn or clean your house is part of GDP, but doing these tasks
yourself is not part of GDP. One remarkable change in the U.S. economy in recent decades is the growth in women’s
participation in the labor force. As of 1970, only about 42% of women participated in the paid labor force. By the
second decade of the 2000s, nearly 60% of women participated in the paid labor force according to the Bureau of
Labor Statistics. As women are now in the labor force, many of the services they used to produce in the non-market
economy like food preparation and child care have shifted to some extent into the market economy, which makes the
GDP appear larger even if people actually are not consuming more services.
GDP has nothing to say about the level of inequality in society. GDP per capita is only an average. When GDP per
capita rises by 5%, it could mean that GDP for everyone in the society has risen by 5%, or that GDP of some groups
has risen by more while that of others has risen by less—or even declined. GDP also has nothing in particular to say
about the amount of variety available. If a family buys 100 loaves of bread in a year, GDP does not care whether they
are all white bread, or whether the family can choose from wheat, rye, pumpernickel, and many others—it just looks
at the total amount the family spends on bread.
Likewise, GDP has nothing much to say about what technology and products are available. The standard of living in,
for example, 1950 or 1900 was not affected only by how much money people had—it was also affected by what they
could buy. No matter how much money you had in 1950, you could not buy an iPhone or a personal computer.
In certain cases, it is not clear that a rise in GDP is even a good thing. If a city is wrecked by a hurricane, and then
experiences a surge of rebuilding construction activity, it would be peculiar to claim that the hurricane was therefore
economically beneficial. If people are led by a rising fear of crime, to pay for installing bars and burglar alarms on all
their windows, it is hard to believe that this increase in GDP has made them better off. Similarly, some people would
argue that sales of certain goods, like pornography or extremely violent movies, do not represent a gain to society’s
standard of living.
Does a Rise in GDP Overstate or Understate the Rise in the Standard of
Living?
The fact that GDP per capita does not fully capture the broader idea of standard of living has led to a concern that
the increases in GDP over time are illusory. It is theoretically possible that while GDP is rising, the standard of
living could be falling if human health, environmental cleanliness, and other factors that are not included in GDP are
worsening. Fortunately, this fear appears to be overstated.
In some ways, the rise in GDP understates the actual rise in the standard of living. For example, the typical workweek
for a U.S. worker has fallen over the last century from about 60 hours per week to less than 40 hours per week.
Life expectancy and health have risen dramatically, and so has the average level of education. Since 1970, the air
and water in the United States have generally been getting cleaner. Companies have developed new technologies
for entertainment, travel, information, and health. A much wider variety of basic products like food and clothing
is available today than several decades ago. Because GDP does not capture leisure, health, a cleaner environment,
the possibilities that new technology creates, or an increase in variety, the actual rise in the standard of living for
Americans in recent decades has exceeded the rise in GDP.
On the other side, crime rates, traffic congestion levels, and income inequality are higher in the United States now
than they were in the 1960s. Moreover, a substantial number of services that women primarily provided in the non-
market economy are now part of the market economy that GDP counts. By ignoring these factors, GDP would tend
to overstate the true rise in the standard of living.
Visit this website (http://openstaxcollege.org/l/amdreamvalue) to read about the American Dream and
standards of living.

GDP is Rough, but Useful

A high level of GDP should not be the only goal of macroeconomic policy, or government policy more broadly. Even
though GDP does not measure the broader standard of living with any precision, it does measure production well
and it does indicate when a country is materially better or worse off in terms of jobs and incomes. In most countries,
a significantly higher GDP per capita occurs hand in hand with other improvements in everyday life along many
dimensions, like education, health, and environmental protection.
No single number can capture all the elements of a term as broad as “standard of living.” Nonetheless, GDP per capita
is a reasonable, rough-and-ready measure of the standard of living.
How is the Economy Doing? How Does One Tell?

To determine the state of the economy, one needs to examine economic indicators, such as GDP. To calculate
GDP is quite an undertaking. It is the broadest measure of a nation’s economic activity and we owe a debt to
Simon Kuznets, the creator of the measurement, for that.
The sheer size of the U.S. economy as measured by GDP is huge—as of the fourth quarter of 2016, $18.9
trillion worth of goods and services were produced annually. Real GDP informed us that the 2008–2009
recession was severe and that the recovery from that recession has been slow, but the economy is improving.
GDP per capita gives a rough estimate of a nation’s standard of living. This chapter is the building block for
other chapters that explore more economic indicators such as unemployment, inflation, or interest rates, and
perhaps more importantly, will explain how they are related and what causes them to rise or fall.
KEY TERMS
business cycle the economy's relatively short-term movement in and out of recession
depreciation the process by which capital ages over time and therefore loses its value
depression an especially lengthy and deep decline in output
double counting a potential mistake to avoid in measuring GDP, in which output is counted more than once as it
travels through the stages of production
durable good long-lasting good like a car or a refrigerator
exchange rate the price of one currency in terms of another currency
final good and service output used directly for consumption, investment, government, and trade purposes; contrast
with “intermediate good”
GDP per capita GDP divided by the population
gross domestic product (GDP) the value of the output of all goods and services produced within a country in a year
gross national product (GNP) includes what is produced domestically and what is produced by domestic labor and
business abroad in a year
intermediate good output provided to other businesses at an intermediate stage of production, not for final users;
contrast with “final good and service”
inventory good that has been produced, but not yet been sold
national income includes all income earned: wages, profits, rent, and profit income
net national product (NNP) GDP minus depreciation
nominal value the economic statistic actually announced at that time, not adjusted for inflation; contrast with real value
nondurable good short-lived good like food and clothing
peak during the business cycle, the highest point of output before a recession begins
real value an economic statistic after it has been adjusted for inflation; contrast with nominal value
recession a significant decline in national output
service product which is intangible (in contrast to goods) such as entertainment, healthcare, or education
standard of living all elements that affect people’s happiness, whether people buy or sell these elements in the market
or not
structure building used as residence, factory, office building, retail store, or for other purposes
trade balance gap between exports and imports
trade deficit exists when a nation's imports exceed its exports and it calculates them as imports –exports
trade surplus exists when a nation's exports exceed its imports and it calculates them as exports – imports
trough during the business cycle, the lowest point of output in a recession, before a recovery begins

KEY CONCEPTS AND SUMMARY

6.1 Measuring the Size of the Economy: Gross Domestic Product
Economists generally express the size of a nation’s economy as its gross domestic product (GDP), which measures
the value of the output of all goods and services produced within the country in a year. Economists measure GDP
by taking the quantities of all goods and services produced, multiplying them by their prices, and summing the
total. Since GDP measures what is bought and sold in the economy, we can measure it either by the sum of what is
purchased in the economy or what is produced.
We can divide demand into consumption, investment, government, exports, and imports. We can divide what is
produced in the economy into durable goods, nondurable goods, services, structures, and inventories. To avoid double
counting, GDP counts only final output of goods and services, not the production of intermediate goods or the value
of labor in the chain of production.
6.2 Adjusting Nominal Values to Real Values

The nominal value of an economic statistic is the commonly announced value. The real value is the value after
adjusting for changes in inflation. To convert nominal economic data from several different years into real, inflation-
adjusted data, the starting point is to choose a base year arbitrarily and then use a price index to convert the
measurements so that economists measure them in the money prevailing in the base year.
6.3 Tracking Real GDP over Time

Over the long term, U.S. real GDP have increased dramatically. At the same time, GDP has not increased the same
amount each year. The speeding up and slowing down of GDP growth represents the business cycle. When GDP
declines significantly, a recession occurs. A longer and deeper decline is a depression. Recessions begin at the
business cycle's peak and end at the trough.
6.4 Comparing GDP among Countries

Since we measure GDP in a country’s currency, in order to compare different countries’ GDPs, we need to convert
them to a common currency. One way to do that is with the exchange rate, which is the price of one country’s currency
in terms of another. Once we express GDPs in a common currency, we can compare each country’s GDP per capita
by dividing GDP by population. Countries with large populations often have large GDPs, but GDP alone can be a
misleading indicator of a nation's wealth. A better measure is GDP per capita.
6.5 How Well GDP Measures the Well-Being of Society

GDP is an indicator of a society’s standard of living, but it is only a rough indicator. GDP does not directly take
account of leisure, environmental quality, levels of health and education, activities conducted outside the market,
changes in inequality of income, increases in variety, increases in technology, or the (positive or negative) value that
society may place on certain types of output.
SELF-CHECK QUESTIONS
1. Country A has export sales of $20 billion, government purchases of $1,000 billion, business investment is $50
billion, imports are $40 billion, and consumption spending is $2,000 billion. What is the dollar value of GDP?
2. Which of the following are included in GDP, and which are not?
a. The cost of hospital stays
b. The rise in life expectancy over time
c. Child care provided by a licensed day care center
d. Child care provided by a grandmother
e. A used car sale
f. A new car sale
g. The greater variety of cheese available in supermarkets
h. The iron that goes into the steel that goes into a refrigerator bought by a consumer.
3. Using data from Table 6.5 how much of the nominal GDP growth from 1980 to 1990 was real GDP and how
much was inflation?
4. Without looking at Table 6.7, return to Figure 6.10. If we define a recession as a significant decline in national
output, can you identify any post-1960 recessions in addition to the 2008-2009 recession? (This requires a judgment
call.)
5. According to Table 6.7, how often have recessions occurred since the end of World War II (1945)?
6. According to Table 6.7, how long has the average recession lasted since the end of World War II?
7. According to Table 6.7, how long has the average expansion lasted since the end of World War II?
8. Is it possible for GDP to rise while at the same time per capita GDP is falling? Is it possible for GDP to fall while
per capita GDP is rising?
9. The Central African Republic has a GDP of 1,107,689 million CFA francs and a population of 4.862 million. The
exchange rate is 284.681CFA francs per dollar. Calculate the GDP per capita of Central African Republic.
10. Explain briefly whether each of the following would cause GDP to overstate or understate the degree of change
in the broad standard of living.
a. The environment becomes dirtier
b. The crime rate declines
c. A greater variety of goods become available to consumers
d. Infant mortality declines
REVIEW QUESTIONS
11. What are the main components of measuring GDP 16. How do you convert a series of nominal economic
with what is demanded? data over time to real terms?
12. What are the main components of measuring GDP 17. What are typical GDP patterns for a high-income
with what is produced? economy like the United States in the long run and the
short run?
13. Would you usually expect GDP as measured by
what is demanded to be greater than GDP measured by 18. What are the two main difficulties that arise in
what is supplied, or the reverse? comparing different countries's GDP?
14. Why must you avoid double counting when 19. List some of the reasons why economists should
measuring GDP? not consider GDP an effective measure of the standard
of living in a country.
15. What is the difference between a series of
economic data over time measured in nominal terms
versus the same data series over time measured in real
terms?
CRITICAL THINKING QUESTIONS

20. U.S. macroeconomic data are among the best in the 22. Should people typically pay more attention to their
world. Given what you learned in the Clear It Up "How real income or their nominal income? If you choose the
do statisticians measure GDP?", does this surprise you, latter, why would that make sense in today’s world?
or does this simply reflect the complexity of a modern Would your answer be the same for the 1970s?
economy?
23. Why do you suppose that U.S. GDP is so much
21. What does GDP not tell us about the economy? higher today than 50 or 100 years ago?

24. Why do you think that GDP does not grow at a 26. Why might per capita GDP be only an imperfect
steady rate, but rather speeds up and slows down? measure of a country’s standard of living?
25. Cross country comparisons of GDP per capita 27. How might you measure a “green” GDP?
typically use purchasing power parity equivalent
exchange rates, which are a measure of the long run
equilibrium value of an exchange rate. In fact, we used
PPP equivalent exchange rates in this module. Why
could using market exchange rates, which sometimes
change dramatically in a short period of time, be
misleading?
PROBLEMS
28. Last year, a small nation with abundant forests cut 30. A mortgage loan is a loan that a person makes
down $200 worth of trees. It then turned $100 worth to purchase a house. Table 6.11 provides a list of the
of trees into $150 worth of lumber. It used $100 worth mortgage interest rate for several different years and
of that lumber to produce $250 worth of bookshelves. the rate of inflation for each of those years. In which
Assuming the country produces no other outputs, and years would it have been better to be a person borrowing
there are no other inputs used in producing trees, lumber, money from a bank to buy a home? In which years
and bookshelves, what is this nation's GDP? In other would it have been better to be a bank lending money?
words, what is the value of the final goods the nation
produced including trees, lumber and bookshelves? Mortgage Interest Inflation
Year
29. The “prime” interest rate is the rate that banks Rate Rate
charge their best customers. Based on the nominal 1984 12.4% 4.3%
interest rates and inflation rates in Table 6.10, in which
of the years would it have been best to be a lender? 1990 10% 5.4%
Based on the nominal interest rates and inflation rates in
2001 7.0% 2.8%
Table 6.10, in which of the years given would it have
been best to be a borrower? Table 6.11
Year Prime Interest Rate Inflation Rate

31. Ethiopia has a GDP of $8 billion (measured in U.S.
1970 7.9% 5.7% dollars) and a population of 55 million. Costa Rica has
a GDP of $9 billion (measured in U.S. dollars) and a
1974 10.8% 11.0% population of 4 million. Calculate the per capita GDP for
1978 9.1% 7.6% each country and identify which one is higher.
1981 18.9% 10.3% 32. In 1980, Denmark had a GDP of $70 billion
(measured in U.S. dollars) and a population of 5.1
Table 6.10 million. In 2000, Denmark had a GDP of $160 billion
(measured in U.S. dollars) and a population of 5.3
million. By what percentage did Denmark’s GDP per
capita rise between 1980 and 2000?
33. The Czech Republic has a GDP of 1,800 billion

koruny. The exchange rate is 25 koruny/U.S. dollar. The
Czech population is 20 million. What is the GDP per
capita of the Czech Republic expressed in U.S. dollars?

Measuring
National
Output/Income
Professor
Coverage:
• Measuring Economic Output
• Product Approach
• Income Approach
• Expenditure Approach
• Problems of measuring GDP
• Real Vs Nominal Income, other measures of development
• Measures of Wellbeing such as HDI, Gross National Happiness Index, etc.
• Economic Growth vs Economic Development
• The implication of Economic Growth
Measuring Economic Output
● Output defined in two ways:
1. Production side: output = payments to workers (wages), capital (interest

and dividends)
2. Demand side: output = purchases by different sectors of the economy
● Output is typically measured as Gross Domestic Product (GDP). It is the value

of all final goods and services produced within a country over a particular
period of time.
Measuring GDP
GDP is the value of final goods and services currently produced within a country over a period of
time.
1. Final goods and services (NO DOUBLE COUNTING): E.g. Would not include the full price of a
car AND the tires bought by the manufacturer for the car → tires = intermediate goods
2. Goods and services currently (in the time period being considered) produced & excludes
transactions involving used goods. E.g. Include the construction of new homes in current GDP,
but not the sale of existing homes.
3. Goods and services produced within a country, regardless of the ownership/nationality of the
producing firm. E.g. Include the sale of a car produced by a Japanese car manufacturer located
in the U.S. in U.S. GDP
What Is Counted and Not Counted in
GDP?
1. GDP includes all items produced in the economy and sold
legally in markets.
2. GDP excludes services that are produced and consumed at
home and that never enter the marketplace.
3. Caring labor, the work that is normally produced by women.
4. Because GDP does not count it, it diminishes its importance.
5. GDP also excludes black market items, such as illegal drugs.
The Components of GDP
GDP (Y ) is the sum of the following:

▪ Consumption (C)
▪ Investment (I)
▪ Government Purchases (G)
▪ Net Exports (NX)=X-M
Y = C + I + G + (X-M)
Problems of GDP Measurement
● Three major criticisms of the GDP measure:
1. Omits non-market goods and services. Ex. Work of stay-at-home mothers
and fathers not included in GDP
2. No accounting for “bads” such as crime and pollution. Ex. Crime is a
detriment to society, but there is no subtraction from GDP to account for it
3. No correction for quality improvements. Ex. Technological improvements
are beneficial to the economy, but nothing is added to GDP to account for
them
● The Human Development Index (HDI) is a statistical tool used to measure a
country's overall achievement in its social and economic dimensions. The
social and economic dimensions of a country are based on the health of
people, their level of education attainment and their standard of living.
Calculating GDP: Expenditure Approach
● A method of computing GDP that measures the total amount spent on all final
goods and services during a given period.
● The four main categories of expenditure:
1. Personal consumption expenditures (C): household spending on consumer
goods
● 2. Gross private domestic investment (I): spending by firms and households
on new capital, that is, plant, equipment, inventory, and new residential
structures
● 3. Government consumption and gross investment (G)
● 4. Net exports (EX - IM): net spending by the rest of the world, or exports (EX)
minus imports (IM)
GDP = C + I + G + (EX − IM)
Calculating GDP: Earnings or Income Approach
● A method of computing GDP that measures the income—wages, rents, interest,
and profits—received by all factors of production in producing final goods and
services.
● National Income: The total income earned by the factors of production owned
by a country’s citizens.
● Compensation of Employees: Includes wages, salaries, and various
supplements.
● Proprietors’ Income: The income of unincorporated businesses.
● Rental Income: The income received by property owners in the form of rent.
● Corporate Profits: The income of corporations.
● Net Interest: The interest paid by business
● Indirect Taxes minus Subsidies
● Net Business Transfer Payments
● Surplus of Government Enterprises
GDP in a Circular Flow of Macroeconomic Activity
Gross Domestic
Product can be
measured either as:
(a ) a flow of final
products or,
equivalently
(b ) a flow of earnings
or incomes
National Product and Income Accounts
The Flow-of-Product Approach
● The product approach of national income accounting measures the addition
of value to the raw material (intermediate goods) by a firm, during its
productive activities.
● The concept of value addition is essential to the practice of producing final

goods with the help of raw materials.
● It is calculated as the difference between value of output and value of

intermediate consumption. Intermediate consumption refers to the value of
raw materials used in the production process.
● Value Added = Value of Output – Intermediate Consumption

The Flow-of-Product Approach..
● Value Added = Value of Output – Intermediate Consumption
● Example: let us suppose that a baker needs only flour to produce bread. He
purchases flour as inputs worth Rs. 500 from the miller and then by virtue of
its productive activities, converts the flour into bread and sells the bread for
Rs. 700.
● Now, in this example, the flour purchased by the baker is his intermediate
consumption, and the bread that he produced is the final output.
● The value added, in this case is
● Value of Output - Intermediate Consumption. = Rs. 700 – Rs 500 = Rs. 200

The Expenditure Approach
Components of GDP, 2017: Billions of Dollars Percentage of GDP
1. Personal consumption expenditures (C) 10,089.1 70.8
Durable goods 1,035.0 7.3
Nondurable goods 2,220.2 15.6
Services 6,833.9 47.9
2. Gross private domestic investment (l) 1,628.8 11.4
Nonresidential 1,388.8 9.7
Residential 361.0 2.5
Change in business inventories −120.9 −0.8
3. Government consumption and gross investment 2,930.7 20.5
(G)
Federal 1,144.8 8.0
State and local 1,786.9 12.5
4. Net exports (EX – IM) -392.4 - 2.8
Exports (EX) 1,564.2 11.0
Imports (IM) 1,956.6 13.7
Gross Domestic Product 14,256.3 100.0
Note: Numbers may not add exactly because of rounding.
The Earnings or Income Approach
Billions of Percentage of National
Components of National Income, 2017:
Dollars Income
National income 12,280.0 100.0

Compensation of employees 7,783.5 63.4
Proprietors’ income 1,041.0 8.5
Rental income 268.1 2.2
Corporate profits 1,308.9 10.7
Net interest 788.2 6.4
Indirect taxes minus subsidies 964.3 7.9
Net business transfer payments 134.1 1.1
Surplus of government enterprises -8.1 -0.1
GDP, GNP, NNP, and National Income,
2017
USD bns
GDP 14,256.3
Plus: Receipts of factor income from the rest of the +589.4
world
Less: Payments of factor income to the rest of the -484.5
world
Equals: GNP 14,361.2
Less: Depreciation -1,864.0
Equals: Net national product (NNP) 12,497.2
Less: Statistical discrepancy -217.3
Equals: National income 12,280.0
An Example:
Nominal GDP Inflation

Real GDP
GDP Deflator Rate
2015 $46,200 $46,200 100.0 n.a.
2016 51,400 50,000 102.8 2.8%
2017 58,300 52,000 112.1 9.3%

Production Account
• GDP at Factor Cost = All factor incomes paid out to suppliers of factor services, i.e. wages,
salaries, dividends, interest and rent + Retained profits + Corporate profit tax + Depreciation =
= 85 + 6 + 3 + 1 + 5 = 100
• NDP at Factor Cost = GDP at factor cost – Depreciation = 100 – 5 = 95
The Household Sector Account
Private Income = Income from Domestic Production accruing to the Private Sector + Net Factor
Income from Abroad + Current Transfers from Government + Net Transfers from RoW to the
Private Sector = 95 + (4 – 5) + 2 + (3 – 5) = 94
Personal Income = Private Income – Retained Profits – Corporate Profits Tax = 94 – 3 – 1 = 90

The Government Account
Personal Disposable Income = Personal Income – Personal Income Tax = 90 – 10 = 80

The External Account
The Savings-Investment Account
Estimations Using The Example
● GDP at Market Prices = GDP at Factor Cost + Indirect Taxes – Subsidies =
100 + 6 – 3 = 103 = C + I + G + X – M = 78 + 12 + 10 + 8 – 5 = 103
● GNP at Market Prices = GDP at Market Prices + Net Factor Income from
Abroad (NFIA) = 103 + (4 – 5) = 102
● GNP at Factor Cost = GDP at Factor Cost + NFIA = 100 – 1 = 99
● GNP at Market Prices = GNP at Factor Cost + Indirect Taxes – Subsidies =

99 + 6 – 3 = 102 as above.
Estimations Using The Example…
● Gross Domestic Saving = Household Saving + Gross Business Saving +
Government Saving = 2 + 8 + 1 = 11
● Gross Domestic Capital Formation = Gross Fixed Investment + Inventory

Investment = 10 + 2 = 12
● GDCF = 12 = GDS + Deficit on Current Account = 11 + 1 = 12
● GDCF + Foreign Investment = GDS (Note that surplus = – Deficit)

Real GDP and the Price Level
Measuring Economic Growth Rate
● For an economy to experience continued prosperity GDP must grow
at a faster rate than the population.
● GDP growth can be determined using the rate of change formula:

Current GDP – Previous GDP x 100
Previous GDP
• Real Economic Growth Rate is the rate at which a nation's Gross
Domestic product (GDP) changes/grows from one year to
another.
Oddities of Measuring National Income
1. Non-market Production
2. Imputed Values
3. The Underground Economy
4. “Side Effects” and Economic “Bads”
5. Leisure and Human Costs
6. Double Counting
The top 10 countries
based on GDP per capita
according to Statistics
Times are:
1. Luxembourg: $113,197
2. Switzerland: $83,717
3. Macao: $81,152
4. Norway: $77,976
5. Ireland: $77,771
6. Qatar: $69,688
7. Iceland: $67,037
8. United States: $65,112
9. Singapore: $63,987
10. Denmark: $59,795
It's a good representation of a
country's standard of living.
Why Do We Measure Economic Growth?
● The economic growth rate is the percentage change in the quantity

of goods and services produced from one year to the next.
● We measure economic growth so that we can make:
1. economic welfare comparisons
2. as an instrument of economic planning and review
3. business cycle forecasts
4. international welfare comparisons
Economic Welfare Comparisons
1. Economic welfare measures the nation’s overall state of economic
wellbeing.
2. Real GDP is not a perfect measure of economic welfare for seven reasons:
a) Quality improvements tend to be neglected in calculating real GDP.
b) Real GDP does not include household production.
c) Real GDP, as measured, omits the underground economy.
d) Health and life expectancy are not directly included in real GDP.
e) Leisure time, a valuable component of an individual’s welfare, is not
included in real GDP.

f) Environmental damage is not deducted from real GDP.
g) Political freedom and social justice are not included in real GDP.
Business Cycle Forecasts
● 1. Real GDP is used to measure business cycle

fluctuations.
● 2. These fluctuations are probably accurately timed

but the changes in real GDP probably overstate the
changes in total production and people’s welfare
caused by business cycles.
International Comparisons
● 1. Real GDP is used to compare economic welfare in one
country with that in another.
● 2. Two special problems arise in making these comparisons.
a) Real GDP of one country must be converted into the
same currency units as the real GDP of the other
country, so an exchange rate must be used.
b) The same prices should be used to value the goods and
services in the countries being compared, but often are
not.
Economy Comparisons
World's 10 Largest Economies Using Nominal GDP World's 10 Largest Economies Using PPP
1. United States: $20.4 trillion 1. China: $25.2 trillion

2. China: $14.0 trillion 2. US: $20.4 trillion
3. Japan: $5.1 trillion 3. India: $10.3 trillion
4. Germany: $4.2 trillion 4. Japan: $5.6 trillion
5. United Kingdom: $2.9 trillion 5. Germany: $4.3 trillion
6. France: $2.9 trillion 6. Russia: $4.1 trillion
7. India: $2.8 trillion 7. Indonesia: $3.4 trillion
8. Italy: $2.1 trillion 8. Brazil: $3.3 trillion
9. Brazil: $2.1 trillion 9. United Kingdom: $3.1 trillion
10. Canada: $1.7 trillion 10. France: $3.1 trillion
The $88 Trillion World
Economy in One Chart
Source: https://www.visualcapitalist.com/
The World’s Richest Families in 2020
Changes in GDP
The level of output (income and expenditures) is The level of output (income and expenditures)
changed if there is a change in AGGREGATE is changed if there is a change in AGGREGATE
DEMAND. SUPPLY.
Consumer Price Inflation vs. GDP Deflator
Items CPI GDP Deflator
1. Prices of Capital Goods Excluded Included
2. Prices of Imported
Included Excluded
Consumer Goods
3. The basket of goods Fixed Changes every year

Aggregate Output
● Aggregate Output is another term for Gross Domestic Product (GDP). It's the
total value of goods and services produced in an economy and is usually
measured during a fiscal year. GDP represents the output of goods and
services at market prices. The term domestic means it's a measurement of
output from within a country' borders. Therefore, the measurement
inherently excludes net income from abroad.
● There are two main criticisms of GDP:
1. One is its preoccupation with indiscriminate consumption and
production.
2. The second is its exclusion of the lost value of depleted natural
resources and unpaid costs of environmental harm while including as a
positive factor in its calculations the cost of damage caused by
pollution.
Aggregate Income
● Aggregate income refers to the total amount of all income earned in an
economy within a given period of time.
● This basis is one way to estimate, or determine, the gross domestic product.
● Aggregate income does not factor in the affect of taxes or inflation on the
income.
● Generally, the more income a country earns overall, the more prosperous the
country is considered to be.
● Although GDP itself is measured on a fiscal basis, aggregate income is
calculated on a quarterly basis.
Human Development Index (HDI)
● The Human Development Index (HDI) is a summary measure of
average achievement in key dimensions of human development: a
long and healthy life, being knowledgeable and have a decent
standard of living.
● The HDI is the geometric mean of normalized indices for each of the
three dimensions.
Human Development Index Trends,
1990-2017
HDI rank Country Human Development Index (HDI)

1990 2000 2010 2012 2014 2015 2016 2017
1 Norway 0.850 0.917 0.942 0.942 0.946 0.948 0.951 0.953
13 US 0.860 0.885 0.914 0.918 0.918 0.920 0.922 0.924
130 India 0.427 0.493 0.581 0.600 0.618 0.627 0.636 0.640
189 Niger 0.210 0.252 0.318 0.336 0.345 0.347 0.351 0.354
Gross National Happiness Index
▪ The Gross National Happiness Index is a single number index developed
from 33 indicators categorized under nine domains. The GNH Index is
constructed based upon a robust multidimensional methodology known
as the Alkire-Foster method
▪ The concept implies that sustainable development should take a holistic
approach towards notions of progress and give equal importance to non-
economic aspects of wellbeing.
▪ The concept of GNH has often been explained by its four pillars: (1)good
governance, (2)sustainable socio-economic development, (3)cultural
preservation, and (4)environmental conservation.
Economic Growth vs Economic Development
Economic Growth Economic Development

Economic Growth is a narrower Economic development is a
concept than economic normative concept i.e. it applies in
development. It is an increase in a the context of people's sense of
country's real level of national output morality
which can be caused by an increase
in the quality of resources.
The most accurate method of measuring development is the Human

Development Index which takes into account the literacy rates & life
expectancy which affect productivity and could lead to Economic Growth.
Green Economy Indicators
Green Economy Indicators are key evidence-based instruments
which facilitate the evaluation of Green Economy policies by:
▪ (a) identifying priority issues
▪ (b) formulating and assessing Green Economy policy options
▪ (c) evaluating the performance of policy implementation.
The OECD Green Growth Measurement Framework
♦ Environmental and resource productivity, to capture the need for

efficient use of natural capital and to capture aspects of production which
are rarely quantified in economic models and accounting frameworks.
♦ Economic and environmental assets, because sustained growth
requires the asset base to be maintained and because a declining asset
base presents risks to future growth. Particular attention is given to natural
assets.
♦ Environmental quality of life, to capture how environmental conditions
and amenities interact with people’s lives.
♦ Economic opportunities and policy responses, to help effectiveness of
policy in delivering green growth.
UNDP Indicators of Green Economy
The Implication of Economic Growth
The benefits of economic growth include:
1. Higher average incomes
2. Lower unemployment
3. Lower government borrowing
4. Improved public services
5. Money can be spent on protecting the environment
6. Investment
7. Increased research and development
Keywords
▪ Expenditure Approach
▪ Income Approach
▪ Product Approach
▪ Nominal GDP
▪ Real GDP
▪ GDP Deflator
▪ Economic Growth Rate
▪ Aggregate Output
▪ Aggregate income
▪ Human Development Index (HDI)
▪ Gross National Happiness Index
MCQ1
1. If GNP is greater than the GDP of a country then
a) Its value of exports is more than the value of imports
b) Its value of imports is more than the value of exports
c) Net factor income from abroad is Negative
d) Net factor income from abroad is positive
e) Net factor income is zero
MCQ1
1. If GNP is greater than the GDP of a country then
a) Its value of exports is more than the value of imports
b) Its value of imports is more than the value of exports
c) Net factor income from abroad is Negative
d) Net factor income from abroad is positive
e) Net factor income is zero
MCQ2
M/S Surya Limited’s total sales revenue for the year 2019-20 is Rs. 500
crores, consumption of intermediate goods is Rs. 200 crores and unsold
items at the end of the year is Rs. 50 crores. Calculate the Gross Value
Added of ABC limited
a. Rs. 300 crores
b. Rs. 350 crores
c. Rs. 250 crores
d. Rs. 750 crores
e. Rs.450 crores
MCQ2
M/S Surya Limited’s total sales revenue for the year 2019-20 is Rs. 500
crores, consumption of intermediate goods is Rs. 200 crores and unsold
items at the end of the year is Rs. 50 crores. Calculate the Gross Value
Added of ABC limited
a. Rs. 300 crores
b. Rs. 350 crores
c. Rs. 250 crores
d. Rs. 750 crores
e. Rs.450 crores
MCQ2
A small island nation has the following macroeconomic information. GDP = $25000
million, Private consumption expenditure = $20000 mn, Business fixed investment =
$3000 mn, Inventory = $1000 mn, Residential investment = $500 mn, Government
spending = $2000 mn, Tax revenue of the government from production and imports =
$1000 mn.
Net exports (X-M) of the economy is
a) $500 mn
b) -$1500 mn
c) $1500 mn
d) $2000 mn
e) -$500 mn
MCQ2
A small island nation has the following macroeconomic information. GDP = $25000
million, Private consumption expenditure = $20000 mn, Business fixed investment =
$3000 mn, Inventory = $1000 mn, Residential investment = $500 mn, Government
spending = $2000 mn, Tax revenue of the government from production and imports =
$1000 mn.
Net exports (X-M) of the economy is
a) $500 mn
b) -$1500 mn
c) $1500 mn
d) $2000 mn
e) -$500 mn
MCQ3
In expenditure approach, which of the following is not included in
investment expenditure of the economy?
a) Cost of new machinery of a factory
b) Cost of a newly constructed house
c) Investment in mutual fund
d) Cost of construction of a new office building
e) Cost of new robots bought by company
MCQ3
In expenditure approach, which of the following is not included in
investment expenditure of the economy?
a) Cost of new machinery of a factory
b) Cost of a newly constructed house
c) Investment in mutual fund
d) Cost of construction of a new office building
e) Cost of new robots bought by company
MCQ4
Index of industrial production (IIP) represents
a) Agricultural sector
b) Manufacturing Sector
c) Service Sector
d) External sector
e) Domestic sector
MCQ4
Index of industrial production (IIP) represents
a) Agricultural sector
b) Manufacturing Sector
c) Service Sector
d) External sector
e) Domestic sector
MCQ5
Gross Happiness Index (GHI) is used in
a) India
b) Pakistan
c) Bhutan
d) China
e) Sri Lanka
MCQ5
Gross happiness Index (GNI) is used in
a) India
b) Pakistan
c) Bhutan
d) China
e) Sri Lanka
Thank you.
That’s all for
this session!

Vighneswara Swamy
New Keynesian Economics - Econlib https://www.econlib.org/library/Enc/NewKeynesianEconomics.html?to_...
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Determination of
Equilibrium Income -
Keynesian Approach
Professor
Coverage:
• Consumption function
• Keynes Psychological Law of Consumption
• Marginal Propensity to Consume
• Marginal Propensity to Save
• Average Propensity to Consume
• Average Propensity to Save
• Determinants of Consumption
• Factors influencing consumption
• Saving function, Investment function
• Investment demand curve, Shift in the investment demand curve,
• Determinants of Investment,
• Types of investment-Private Vs. Public, Induced Vs. Autonomous, Gross vs. Net
investment, Business fixed investment, Residential investment, Inventory investment,
• Implications of Investment in an Economy
• How a change in interest rate affect aggregate demand?
2
Keynesian Income Determination Models
Private sector Public sector International

1. Consumption 1. Government 1. Imports, exports,
demand expenditure net exports
2. Investment Demand 2. Government taxes
3. Supply & demand 3. Monetary policy
for money manipulation of
money supply
3
Psychological Law of Consumption
1. J.M. Keynes, in his book ‘General Theory’ analyzed the consumption behavior of the
community on the basis of human psychology. He propounded a law which is known as
Psychological Law of Consumption.
2. "The household sector spends a major part of its income on the purchase of consumer
goods and services such as food, clothing, medicines, shelter etc., for personal
satisfaction. The expenditure on consumption (C) is the largest component of aggregate
expenditure. Whatever is not consumed out of disposable income is by definition called
saving (S)".
3. Formula: Disposable Income = Consumption + Saving i.e. DI = C + S
4. According to Keynes, the level of consumption in a community depends upon the level of
disposable income. As income increases, consumption also increases but it increases
not as fast as income i.e., it increases at a diminishing rate. This relationship between
consumption and disposable income is called consumption function.
4
Properties of Consumption Behavior
(i) The level of consumption is directly functionally related to the level of
disposable income. C = f(y)
(ii) With the rise in the level of income, the consumption level also rises,
but at a decreasing rate. ΔC < Δy
(iii) As the level of income increases, the households devote a part of the
increase saving. ΔY = ΔC + ΔS
5
Consumption Function
▪Consumption (C)is a major component of Aggregate Demand (AD) and

accounts for about 70% of AD
▪Fluctuations in C are proportionately smaller than the fluctuations in
GDP
▪Consumption is relatively stable.
▪Consumption determines output and income, on the other hand, output
and income also determine consumption.
▪Definition: The relationship between consumption and income is
described by the consumption function .
6
The Consumption Function
The intercept of
equation is the level of
consumption when
ഥ + cY
C=𝑪
income is zero → this
is greater than zero
since there is a
subsistence level of
consumption
Autonomous Income
The slope of equation
Consumption
MPC
is known as the
Marginal Propensity
to Consume (MPC) → Induced
the increase in Consumption
consumption per unit
increase in income.
7
Calculate C for each level of National Income (Y)
Y Ca MPC C
ഥ = Ca
𝑪
100 50 0.50 100
200 60 0.60 180
300 70 0.70 280
400 80 0.80
400
500 90 0.90
540
C ഥ++bY
C ===aa𝑪 +bY= =80
cY ==
100
60
70 50
+90 ++.5
..60
.80
70 (100)=
+(400)
(200)
(300)
.90 == 100=
180
400
280
(500) 540
8
Budget Constraint Equation
ഥ + 𝒄𝒀 𝒘𝒉𝒆𝒓𝒆 𝑪
𝑪=𝑪 ഥ > 𝟎; 𝟎 < 𝒄 < 𝟏
𝑺≡𝒀−𝑪
ഥ − 𝒄𝒀 = −𝑪
𝑺≡𝒀−𝑪=𝒀−𝑪 ഥ+ 𝟏−𝒄 𝒀
Then marginal propensity to save (MPS), s = (1 – c)
9
Consumption Function
▪This consumption function is shown by the
green line.
▪ 𝐶ҧ is the intercept, represents the level of
consumption when income is zero.
▪ 𝐴ҧ is autonomous spending
▪The slope of the consumption function is c
▪ I is the investment
▪45˚ line: at any point on the 45˚line
consumption exactly equals income and the
households have zero saving.
▪MPC i.e. c is the slope of the consumption
function, which measures the change in
consumption per unit change in income.
10
The Consumption Function
C
MPC = C
Y
Real Consumption
3200
DC
2400
= = .80 800
3000
DY
1000 4000
Real Disposable Income
11
12
Determination of Equilibrium Income and Output
▪The 45° line, AD=Y shows point E at which

output and aggregate demand are equal.
▪At that level of output and income, planned
spending precisely matches production.
▪𝐴ҧ is autonomous spending
▪𝐼 ҧ is Investment; 𝐺ҧ is government spending
▪𝑇𝐴 is taxes; 𝑇𝑅 is transfers
▪𝑁𝑋 is net exports
▪IU is unplanned additions to inventory
▪If output is greater than aggregate demand,
there is unplanned inventory investment, IU >0
▪The equilibrium level of output is higher the
larger the marginal propensity to consume, c ,
and the higher the level of autonomous
spending 𝐴.ҧ
13
Keynesian Cross: Income–Expenditure Equilibrium
The Keynesian cross diagram identifies income–expenditure equilibrium as the point where the
planned aggregate spending line crosses the 45-degree line
Income–expenditure equilibrium occurs at E, the
point where the planned aggregate spending line,
AEPlanned, crosses the 45-degree line. At E, the
economy produces real GDP of $2,000 billion per
year, the only point at which real GDP equals
planned aggregate spending, AEPlanned, and
unplanned inventory investment, IUnplanned, is zero.
This is the level of income–expenditure

equilibrium GDP, Y*. At any level of real GDP less
than Y*, AEPlanned exceeds real GDP. As a result,
unplanned inventory investment, IUnplanned, is
negative and firms respond by increasing
production. At any level of real GDP greater than
Y*, real GDP exceeds AEPlanned. Unplanned
inventory investment, IUnplanned, is positive and
firms respond by reducing production.
Developed by Paul Samuelson
14
Autonomous and Induced Consumption
Autonomous consumption Induced consumption
1. Autonomous consumption 1. Induced consumption ‘c’
ഥ occurs when
expenditure 𝑪 describes consumption
income levels are zero. Such expenditure by households on
consumption does not vary with goods and services which varies
changes in income. with income.
2. If income levels are actually zero, 2. Consumption is considered

this consumption is financed by induced by income.
borrowing or using up savings.
15
Marginal Propensity to Consume (MPC)
▪The marginal propensity to consume (MPC) is the extra amount that people consume when they receive an
extra unit of income.
▪Definition: The marginal propensity to consume is the increase in consumption per unit increase in income
▪ 𝑴𝑷𝑪 = ∆𝑪Τ∆𝒀
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑪𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏 ∆𝑪
▪Also, 𝑴𝑷𝑪 = =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑫𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝑰𝒏𝒐𝒎𝒆 ∆𝑫𝑰
▪MPC is the first derivation of consumption function.
▪Induced consumption can be described by formula: 𝑪𝑰 = 𝑴𝑷𝑪 × 𝒀
16
Remember
According to Keynes, the level of consumption in

a community depends upon the level of
disposable income.
17
The Nation’s Marginal Propensity to Consume
According Fluctuatio
to Simon ns in
Kuznets, consumpt
MPC tends ion are
to remain proportion
fairly ately
constant smaller
regardless than
of the fluctuatio
absolute ns in GDP.
level of
national
income.
18
Marginal Propensity to Consume..
According to Keynesian “Psychological Rule-of-thumb” model, marginal

propensity to consume (MPC) is generally high.
However, according to the rational consumer decision model, MPC tends to
be low.
Keynes believed that the MPC decreases as income increases.
The life-cycle hypothesis (Modigliani) views individuals as planning their
consumption and savings behavior over long periods with the intention of
allocating their consumption in the best possible way over the entire life time.
According to Permanent income hypothesis (Milton Friedman), consumption
is proportional to permanent income. Permanent income is the steady state of
expenditure a person could maintain for the rest of his or her life given the
present level of wealth and the income earned now and in the future.
19
Average Propensity to Consume (APC)
The Average Propensity to Consume (APC) is the fraction of income
spent.
It is computed by dividing consumption by income.
APC = C / Y
Sometimes, disposable income is used as the denominator.
Then, APC = C / Y-T
On the other hand, Average Propensity to Save (APS)=1-APC
20
Determinants of Consumption
1. Current Disposable Income
2. Permanent Income
3. Wealth
4. Credit
5. Interest rate
6. Inflation
7. Expectations
8. The level of Economic Activity
9. Stock of Capital
10.Capacity Utilization
11.Cost of Capital Goods
12.Technological Change
13.Public Policy
14.Structural Factors
21
A Numerical Problem
Suppose the level of autonomous investment in an economy is Rs. 2000
crores and consumption function of the economy is: C = 80 + 0.75Y.
What will be the equilibrium level of income?
Ans: Y = C + I Eq (1)
I = 2000 crores
Substituting the values of C and I in (1) we have
Y = 80 + 0.75Y + 2000
(Y – 0.75Y) = 80 + 2000 = 2080
0.25 Y = 2080
Y = 2080 /0.25 = 8320
Equilibrium level of income is therefore equal to 8320 crores.
22
Saving
▪Saving is that part of national income not spent on consumption.
▪Saving equals income minus consumption.
If, Y=C+S
then, S = Y – C
C S C S
+ =1 + =1
Y Y Y Y
23
The Marginal Propensity to Save
The marginal propensity to save is defined as the fraction of
an extra unit of income that goes to extra saving.
S
MPS =
Y
MPC + MPS = 1 because the part of each unit of income that is not
consumed is necessarily saved.
MPC = 1– MPS MPS = 1 – MPC

24
Saving Function
Like consumption, saving is also the function of income:
S = f(Y)
If autonomous consumption exists then autonomous saving
exists as well and saving function is: S = -CA + MPS x Y
Saving is a source for investment.
25
An Illustration
Lets assume that your income increases by $100. We observe
that you increase your consumption by $80. What is your MPC?
C 80
MPC = = = .80
Y 100
S 20
MPS = = = .20
Y 100
26
Determinants of Saving
▪ Income
▪ Expectations
▪ Unemployment
▪ Interest rates
▪ Asset prices
▪ Savings schemes
27
Consumption and Saving
Break-Even Income is the entire income that the households plan to spend.
Average Propensity to Consume (APC) is the proportion of total income

consumed.
Average Propensity to Save (APS) is the proportion of total income saved
Consumption Saving
APC = APS = Income
Income
28
Consumption and Saving..
Marginal Propensity to Consume (MPC) is the proportion of change in
income spent
Marginal Propensity to Save (MPS) is the proportion of change in
income saved
MPC + MPS = 1
Change in Saving
MPS = Change in Income
Change in Consumption
MPC =
Change in Income
29
Relationship Between the Consumption Function
and the Savings Function
Where the consumption line crosses the
45 degree line, Y = C. Hence savings must
be zero. You can see that this is the case
in the bottom diagram.
To the left of this point (Y1), C > Y, so
saving must be negative. Dissaving is
occurring.
To the right of Y1, C < Y, so saving is
positive.
Notice that since MPC + MPS =1, the
gradient of the saving line is '1-b' where 'b'
is the gradient of the consumption line.
30
Investment Spending
Investment
spending is an
injection into the
circular flow of
income.
Investment
In economic theory, net
investment carries more
significance, as it provides the
basis for economic growth.
Investment refers to an
increase in capital assets, and
typically includes investment
by business, investment in
property (‘dwellings’) and
investment by governments in
‘social’ capital.
32
Investment Function
• The investment function is drawn as a

flat line because investment is based on
interest rates and expectations about the
future, and so it does not change with the
level of current national income.
• In this example, investment expenditures

are at a level of 500. However, changes in
factors like technological opportunities,
expectations about near-term economic
growth, and interest rates would all cause
the investment function to shift up or
down.
Investment Function
I Investment plays two roles in

macroeconomics:
1. It can have a major impact on AD
(real output and employment)
I2
I2 2. It leads to capital accumulation (it
I1 increases the nation's potential
I1 output and promotes economic
growth in the long run)
0 Y In the short-run it is reasonable to

assume that investment is independent
of national income.
Investment Function
Investment Function It = AI –f(i)

where:
AI intercept of the investment function, or what investment expenditures
would be if interest rates were zero
f slope of the investment function, or the change in investment with
respect to a change in the interest rate (known as the marginal
efficiency of investment)
i rate of interest
It gross investment expenditures =
Types of Investment
Classification of Investment:
1. Induced Investment
2. Autonomous investment
3. Private Investment
4. Public Investment
5. Gross Investment
6. Net Investment
7. Intended/Ex-ante/Planned/voluntary Investment
8. Unintended/Ex-post/Unplanned/Involuntary Investment
36
Investment Demand Curve
The
investment
demand
curve is a
curve that
shows the
quantity of
investment
demanded at
each interest
rate with all
other
determinant
of
investment
unchanged.
37
Shift in the Investment Demand Curve
1. Acquisition, maintenance, and operating costs
2. Business taxes
3. Technological change
4. Stock of capital goods on hand
5. Planned inventory changes
6. Expectations
7. Level of economic activity
38
Propensity to Invest ( I/Y)
Average Propensity to Marginal Propensity to

Invest Invest
It is the ratio of total investment It is the ratio of change in investment
to total income. to change in income
API = I/Y If income increases by INR10 crore

and as a result investment increases
by 5 crore, then MPI=5/10=.5
39
Determinants of Investment Demand
1. Expectations
2. The level of economic activity
3. The stock of capital
4. Capacity utilization
5. The cost of capital goods
6. Other factor costs
7. Technological change
8. Public policy
40
Measures to Stimulate Investment
PRIVATE INVESTMENT PUBLIC INVESTMENT
1. Reduction in rate of interest 1. Taxation
2. Reduction in taxes 2. Loans
3. Increase in govt. expenditure 3. Deficit financing
4. Price support policy
5. Promotion of research
6. Pump priming
Investment and Aggregate Demand
A
8
Price level
Interest rate (%)
6 C D
1.0
ΔI=$50
ΔAD=$100
ID
AD1 AD2
$950 $1,000 $8,000 $8,100
Investment per year (billions of base year $) Real GDP per year (billions of base year $)
42
Effects of Capital Investment
▪ The initial impact of investment is on the

AD curve, which shifts to the right as
investment (I) is a component of AD.
▪ In the long run, the investment will

increase the economy’s capacity to
produce, which shifts the LRAS curve to
the right. Finally, it is likely that
production costs will fall as new
technology increases efficiency and
reduces average costs. This means that
the SRAS curve shifts to the right. The
combined effects are that the economy
grows, both in terms of potential output
and actual output, without inflationary
pressure.
43
Implications of Spending and Saving in an Economy
▪ ‘Savings investment
culture’ – Higher savings
can help finance higher
levels of investment and
boost productivity over the
longer term.
▪ Consumer spending is the

single most important
driving force of an
economy.
44
Investment and Economic Growth
1. Investment adds to the capital stock
2. An increase in capital stock leads to more consumption
3. The long run AS curve shifts to the right
4. The increase in investment also affects aggregate demand
45
Key points
▪An increase in the marginal propensity to consume will lead to the
consumption function becoming steeper.
▪As national income increases, the average propensity to consume

falls and gets nearer in value to the marginal propensity to
consume.
▪An increase in consumption at any given level of income is likely to

lead to higher aggregate demand.
46
Keywords
▪ Consumption function
▪ Keynesian cross
▪ Income–expenditure equilibrium
▪ Marginal propensity to consume (MPC)
▪ Marginal propensity to save (MPS)
▪ Autonomous Consumption
▪ Induced Consumption
▪ Investment Function
47
Thank you
That’s all for
this session!

Vighneswara Swamy
Product Market
(Multipliers)
Professor
Coverage
1. The concept of multiplier
2. Assumptions of multiplier
3. Importance of multiplier
4. Simple multiplier
5. Two sector and three sector model
6. Types of the multiplier
7. The Government Sector
8. Investment multiplier
9. Foreign trade multiplier
10. Balanced budget multiplier
11. The multiplier in the presence of tax
2
The Concept of Multiplier
1. The concept of multiplier was first of all developed by F.A. Kahn in the early
1930s. But Keynes later further refined it.
2. Whereas Kahn’s multiplier is known as ’employment multiplier’, Keynes’s
multiplier is known as investment or income multiplier.
3. The essence of multiplier is that total increase in income, output or
employment is manifold the original increase in investment.
4. A $1 increase in autonomous spending, in general, increases GDP by much
more than $1. For example, if investment equal to Rs. 100 crores is made,
then the income will not rise by Rs. 100 crores only but a multiple of it.
5. We call the number 1/(1 – mpc) the multiplier, as it describes the amount by
which that initial $1 is multiplied as it changes hands, and is spent again and
again.
3
The Concept of Multiplier
1. The multiplier model gives numerical answers about the effect of
changes in aggregate expenditures on aggregate output.
2. A dollar injected into the economy (i.e. investment) has an impact
beyond the initial expenditures. The dollar continues to be spent
multiplying its impact on the economy.
3. The number of times it circulates through the economy is known as
THE MULTIPLIER.
𝟏 𝟏
𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 = =
𝟏 − 𝑴𝑷𝑪 𝑴𝑷𝑺
4
Assumptions of The Multiplier model
1. The multiplier model assumes that the price level remains constant - and then
explores specific questions about expenditures.
2. The marginal propensity to consume (MPC) remains constant throughout as the
income increases in various rounds of consumption expenditure.
3. There is no any time-lag between the increase in investment and the resultant
increment in income.
4. There exists an excess capacity in the consumer goods industries so that when
the demand for them increases, more amounts of consumer goods can be
produced to meet this demand. If there is no excess capacity in consumer
goods industries, the increase in demand as a result of some original increase in
investment will bring about rise in prices rather than increases in real income,
output and employment.
5
The Multiplier
• Effect of an increase in
autonomous spending on the
equilibrium level of output:
– The initial equilibrium is at
point E, with income at Y0
– If autonomous spending
increases, the AD curve shifts
up by A , and income
increases to Y’
– The new equilibrium is at E’
with income at 
Y0 = Y0 − Y0
10-6
The Multiplier
By how much does a
$1 increase in
autonomous spending
raise the equilibrium
level of income? →
The answer is not $1
◦ Out of an additional
dollar in income, $c is
consumed
◦ Output increases to
meet increased
expenditure; change in
output = (1+c)
◦ Expansion in output
and income results in
further increases
7
The Multiplier
▪If we write out the successive rounds of increased spending, starting with the
initial increase in autonomous demand, we have:
AD = A + cA + c 2 A + c 3A + ...
= A (1 + c + c 2 + c 3 + ...)
1
▪ This is a geometric series, where c < 1, that simplifies to: AD = A = Y0
(1 − c)
▪ Multiplier = amount by which equilibrium output changes when autonomous

aggregate demand increases by 1 unit
Y 1
▪ The general definition of the multiplier is = =
A (1 − c )
8
10-8
The Multiplier Equation
▪The multiplier equation tells us that income equals the multiplier times
autonomous expenditures.
Y = (multiplier) x (autonomous expenditures)
▪The multiplier equation is a useful way to determine the level of income
in the multiplier model.
▪The multiplier is a number that reveals how much income will change in
response to a change in autonomous expenditures.
Multiplier = 1/(1 – mpc)
9
The Multiplier Equation
As the mpc increases, the multiplier increases:
mpc Multiplier = mpc Multiplier =

1/(1-mpc) 1/(1-mpc)
0.5 2.0 0.8 5
0.6 2.5 0.9 10
0.75 4.0 0.95 20
10
Types of the Multiplier
1. Employment Multiplier: Kahn’s Employment Multiplier is a ratio of a change in total
employment to the changes in income.
2. Price Multiplier: refers to the ratio of the ultimate increase in the general price level to the
initial increase in prices (on account of the increased money supply).
3. Consumption Multiplier: the consumption multiplier tells us by how much the consumption of
wage goods in the economy will have to go down, if a given increase in investment has to be
self- financing, whereas the Keynesian multiplier tells us by how much savings will have to go
up if a given increase in investment has to be self-financing
4. Investment Multiplier: refers to the concept that any increase in public or private investment
spending has a more than proportionate positive impact on aggregate income and the general
economy.
5. Income Multiplier: refers to the increase in final income arising from any new injection of
spending.
11
The Multipliers
Y = 1/(1-b) I
Y = 1/(1-b) G
} The Spending Multipliers
Y = -b/(1-b) T } The Policy Multipliers
12
The Multiplier Process
1. The multiplier process amplifies changes in autonomous
expenditures.
2. What forces are operating to ensure that the income level we
determined is actually the equilibrium income level.
3. When expenditures do not equal current output, business
people change planned production:
1. Which changes income, which changes
expenditures,
2. Which changes production, which changes income,
13
The Multiplier Effect
Change in Real GDP
Multiplier =
Initial Change in Spending
The Multiplier and the Marginal Propensities

1 1
Multiplier = -or- Multiplier =
1 - MPC MPS
One person’s spending becomes another’s income…..

14
The Multiplier Tabular and Graphical Views
Effect (1)
Change in
(2)
Change in
Consumption
(3)
Change in
Saving
Income (MPC = .75) (MPC = .25)
Increase in Investment of $5 $ 5.00 $ 3.75 $ 1.25
Second Round 3.75 2.81 .94
Third Round 2.81 2.11 .70
Fourth Round 2.11 1.58 .53
Fifth Round 1.58 1.19 .39
All other rounds 4.75 3.56 1.19
Total $ 20.00 $ 15.00 $ 5.00
$20.00
$4.75
15.25
$1.58
13.67
$2.11
11.56
$2.81
8.75
ΔI=
$5 billion $3.75
5.00
$5.00
1 2 3 4 5 All
Rounds of Spending
15
The Multiplier
Effect The MPC and the Multiplier
MPC Multiplier
.9 10
.8 5
Multiplier = 1/(1 – mpc)
.75 4
.67 3
.5 2
16
Simple Spending Multiplier
A Simple Spending Multiplier is the factor by which real GDP
demanded changes for a given initial change in spending.
𝟏
Simple Spending Multiplier =
𝟏−𝑴𝑷𝑪
The Simple Spending Multiplier provides a shortcut to the total

change in real GDP demanded.
17
Employment Multiplier
▪The original idea of Employment Multiplier was given by R. F. Kahn
▪Employment Multiplier studies the effect of changes in employment on
changes in income as per which the changes in income happens to be
greater than the initial change in employment
▪Algebraically, ∆𝒀 = 𝑲𝒆 ∗ ∆𝑬
▪ΔY stands for change in income
▪Ke stands for Employment Multiplier
▪ΔE stands for initial change in Employment
18
Investment Multiplier
▪The concept of ‘Investment Multiplier’ is an important contribution of Prof. J.M. Keynes.
▪An initial increment in investment increases the final income by many times. The
Investment Multiplier expresses the relationship between an initial increment in
investment and the resulting increase in aggregate income.
▪The larger an investment's multiplier, the more efficient it is at creating and distributing
wealth throughout an economy.
▪Multiplier (k) is the ratio of increase in national income (∆Y) due to an increase in
investment (∆I). K= ΔY/ΔI
▪Suppose an additional investment (∆I) of RS 1,000 crores in an economy generates an
additional income (∆Y) of Rs 4,000 crores. The value of multiplier (k), in this case will
be: k =4,000/1,000 = 4. It means, income increased 4 times with a single increase in
investment.
19
▪The Keynesian investment multiplier model shows that an increase in
investment will increase output by a multiplied amount – by an amount
greater than itself.
▪The multiplier is the number by which the change in investment must be
multiplied in order to determine the resulting change in total output.
▪The size of the multiplier k depends upon how large the MPC is.
Y Y 1 1 1
k= = = = =
I Y − C 1 − C 1 − MPC MPS
Y
C, I C + I2
E2 I2 = I1 + ΔI
C +I1
E1 ΔY = k . ΔI
ΔI Y
k =
I
45
˚
0 Y1 ΔY Y2 Y
Income Multiplier
Income Multiplier is the ratio of the change in equilibrium GDP
to the change in initial spending or autonomous spending.
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝒒𝒖𝒊𝒍𝒊𝒃𝒓𝒊𝒖𝒎 𝑮𝑫𝑷
𝑰𝒏𝒄𝒐𝒎𝒆 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑨𝒖𝒕𝒐𝒏𝒐𝒎𝒐𝒖𝒔 𝑺𝒑𝒆𝒏𝒅𝒊𝒏𝒈
∆𝒀
𝑰𝒏𝒄𝒐𝒎𝒆 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 =
∆𝑨𝑪
Income multiplier refers to the change in income of GDP of the
economy owing to any injection or spending made.
22
Money Multiplier
The Money Multiplier measures how much the money supply increases in
response to a change in the monetary base.
∆𝑴𝒐𝒏𝒆𝒚 𝑺𝒖𝒑𝒑𝒍𝒚
𝑴𝒐𝒏𝒆𝒚 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 =
∆𝑴𝒐𝒏𝒆𝒕𝒂𝒓𝒚 𝑩𝒂𝒔𝒆
The multiplier may vary across countries, and will also vary depending on
what measures of money are considered.
For example, consider M3 (Broad Money) as a measure of Money supply,
and M0 as a measure of the monetary base.
If a $1 increase in M0 by the federal reserve causes M2 to increase by $10,
then the money multiplier is 10/1=10.
23
Government Expenditure Multiplier
▪The government affects the level of equilibrium output in two ways:
▪ Government expenditures (component of AD)
▪ Taxes and transfers
▪In the standard theory, an increase in government expenditure has the
multiplier effect
▪Since the change in consumption is Δc = Δy−Δg, therefore
24
Changes in Taxes
Y = C + I + G, where C = a + b(Y – T)
Y = a + b(Y – T) + I + G
i.e. Y = a + bY – bT + I + G
Suppose T changes by T, causing Y to change by Y.
The new equilibrium is:
Y + Y = a + b(Y + Y) - b(T + T) + I + G
i.e. Y + Y = a + bY + bY - bT -bT + I + G
25
The Government Sector
– Expenditure Multiplier Effect
▪Government purchases are said to have a multiplier effect on aggregate
demand.
▪Each dollar spent by the government can raise the aggregate demand
for goods and services by more than a dollar.
▪If the MPC = 3/4, then the multiplier will be:
▪ Multiplier = 1/(1 – 3/4) = 4
▪In this case, a $20 billion increase in government spending generates
$80 billion of increased demand for goods and services.
Y = 1/(1-b) G
26
The MPC and the Tax Multiplier
▪As with the spending multiplier, the multiple that
relates Y to T is dependent on the MPC= “b” in the
equation
C = a + b(Y – T)
▪We can actually calculate an expression in the form of
Y = (some multiplier)T.
27
The Government Sector – Taxes
Multiplier Effect
1. When the government cuts personal income taxes, it increases
households’ take-home pay.
2. Households save some of this additional income.
3. Households also spend some of it on consumer goods.
4. Increased household spending shifts the aggregate-demand curve to
the right.
5. The size of the shift in aggregate demand resulting from a tax
change is affected by the multiplier and crowding-out effects.
6. It is also determined by the households’ perceptions about the
permanency of the tax change.
Y = -mpc/(1-mpc) T
28
Illustration: Tax Multiplier Effect
Suppose we increase G by 100 and increase T
by 100.
If b = 0.80, what will the net change in Y?
YG = 1/(1-mpc) G YT = -mpc/(1-mpc) T
1/(1-mpc) = 1/(1-0.80) = 5 -mpc/(1-mpc) = -0.80/(1-0.80) = -4
G = 100 T = 100
YG = 5 (100) = 500 YT = -4 (100) = -400
Y = YG + YT = 500 -400 = 100

29
The Government Sector Multiplier Effect
Price
Level
2. . . . but the multiplier

effect can amplify the
shift in aggregate
demand.
$20 billion
AD3
AD2
Aggregate demand,AD1
0 Quantity of
1. An increase in government purchases Output
of $20 billion initially increases aggregate
demand by $20 billion . . . 30
Foreign Trade Multiplier
▪The foreign trade multiplier (also called the export multiplier) operates like the
investment multiplier of Keynes.
▪The Concept of foreign trade multiplier was given by Mr. Leighton.
▪Foreign trade multiplier is defined as the amount by which the national income
of a country will be raised by a unit increase in domestic investment on
exports.
▪As exports increase, there is an increase in the income of all persons associated
with export industries. These in turn create demand for goods. But this is
dependant upon their marginal propensity to save (MPS) and the marginal
propensity to import (MPM). The smaller these two marginal propensities are,
the larger will be the value of multiplier and vice versa.
31
The foreign trade multiplier is based on the following:
1. There is full employment in the domestic economy
2. There is a direct link between domestic and foreign country in exporting and
importing goods and the country is small with no foreign country
3. It is on a fixed exchange rate system The multiplier is based on
instantaneous process without time lag and the domestic Investment (Id)
remains invariable
4. There is no accelerator and the analysis is applicable to only two countries
5. There are no tariff barriers and exchange controls
6. The government expenditure is constant
32
The formula to calculate the foreign trade multiplier (Kf) is
𝟏
𝑲𝒇 =
(𝑴𝑷𝑺+𝑴𝑷𝑴)
∆𝑺
Where MPS is Marginal Propensity to Save (𝑴𝑷𝑺 = )
∆𝒀
∆𝑴
MPM is Marginal Propensity to Import (𝑴𝑷𝑴 = )
∆𝒀
33
The value of MPS = 0.25, and the value of MPM = 0.15
𝟏 𝟏 𝟏
𝑲𝒇 = = =
(𝑴𝑷𝑺 + 𝑴𝑷𝑴) (𝟎. 𝟐𝟓 + 𝟎. 𝟏𝟓) 𝟎. 𝟒𝟎
= 𝟐. 𝟓
∆𝒀 = 𝑲𝒇 ∗ ∆𝑿
If exports increase by 200 i.e. from 300 to 500; ∆𝑿 = 𝟎 ∆𝑰 = 𝟎
∆𝒀 = 𝟐. 𝟓 ∗ 𝟐𝟎𝟎 = 𝟓𝟎𝟎 If Y0=1000
𝒀𝟏 = 𝒀𝟎 + ∆𝒀 = 𝟏𝟎𝟎𝟎 + 𝟓𝟎𝟎 = 𝟏𝟓𝟎𝟎
∆𝑺 = 𝑺∆𝒀 = 𝟎. 𝟐𝟓 ∗ 𝟓𝟎𝟎 = 𝟏𝟐𝟓
∆𝑴 = 𝒎∆𝒀 + 𝟎. 𝟏𝟓 ∗ 𝟓𝟎𝟎 = 𝟕𝟓
34
At the point of changed equilibrium level of national income:
∆𝑰 + ∆𝑿 = ∆𝑺 + ∆𝑴 Therefore 𝟎 + 𝟐𝟎𝟎 = 𝟏𝟐𝟓 + 𝟕𝟓 = 𝟐𝟎𝟎
Generally, K=4 in the closed economy and Kf=2.5 in the open
economy
𝑲𝒇 < 𝑲
Because of two leakages i.e. savings and imports
Balanced Budget Multiplier
▪Balanced Budget Multiplier is the ratio of the change in aggregate output
(GDP) to a change in government spending, which is matched by an equal
change in taxes.
▪This is termed a balanced-budget multiplier because the change in
spending is matched by the change in taxes and thus the government's
budget deficit or surplus is neither increased nor decreased.
▪If the government had a balanced budget before the changes, then it has
one after the changes.
▪The balanced budget multiplier is important in understanding the way
governments manage the economy.
36
Balanced Budget Multiplier
∆Y = ∆T = ∆G Then, ∆Y/ ∆G = ∆Y/ ∆T = 1
The value of BBM (symbolised by KB) is unity. It can also be expressed in the
following way:
𝐾𝐵 = 𝐾𝐺 + 𝐾𝑇
𝟏 𝑴𝑷𝑪 𝟏−𝑴𝑷𝑪 𝟏−𝑴𝑷𝑪
𝑲𝑩 = − = = =𝟏
𝑴𝑷𝑺 𝑴𝑷𝑺 𝑴𝑷𝑺 𝟏−𝑴𝑷𝑪
MPS=1-MPC
Since KG is positive and KT is negative, the net effect of balanced budget is not
neutral. Income changes by an amount equal to a change in government
expenditure and tax receipt. So the value of BBM must be 1. Since KT is one
less than KG, a balanced budget must have a value of one.
37
The Fiscal Multiplier
▪The fiscal multiplier is consistent with the standard Keynesian
multiplier theory. In the standard theory, an increase in
government expenditure has the multiplier effect
▪The change in consumption is proportional to the change in the

government deficit.
38
The Tax Multiplier
▪The Tax multiplier is the change in income 1. TM is negative when a tax
resulting from a unit increase in Tax. increase reduces C, which
reduces income
Y − MPC 1. TM is greater than 1 when a
= change in taxes has a multiplier
T 1 − MPC effect on income.
1. TM is smaller than the
▪If MPC = 0.8, then the tax multiplier equals government spending multiplier
when consumers save the
Y − 0.8 − 0.8 fraction (1-MPC) of a tax cut, so
= = = −4 the initial boost in spending
T 1 − 0.8 0.2 from a tax cut is smaller than
from an equal increase in G
39
The Circular Flow Model and the
Multiplier Process
1. The circular flow model provides the intuition behind the multiplier process.
2. Expenditures are injections into the circular flow.
3. The mpc measures the percentage of expenditures that get injected back
into the economy each round of the circular flow. But there are withdrawals.
4. Economists use the term the marginal propensity of save (mps) to represent
the percentage of income flow that is withdrawn from the economy for each
round of the circular flow.
5. By definition: mpc + mps = 1
6. Alternatively expressed: mps = 1 - mpc
multiplier = 1/mps
40
The Circular Flow Model and the Multiplier Process
41
Limitations of Multiplier Model
1. The Multiplier Model Is Not a Complete Model of the Economy
2. On the surface, the multiplier model makes a lot of intuitive sense.
3. Surface sense can often be misleading.
4. The multiplier model does not determine income from scratch.
5. At best, it can estimate the directions and rough sizes of autonomous
demand or supply shifts.
6. The multiplier model leads people to overemphasize the aggregate
expenditure shifts that would occur in response to a shift in
autonomous expenditures.
42
Keywords
▪The concept of Multiplier
▪Assumptions of Multiplier
▪Simple multiplier
▪Two sector and three sector model
▪Investment multiplier
▪Foreign trade multiplier
▪Balanced Budget multiplier
43
Thank you
That’s all for
this session!

Vighneswara Swamy
Money Market
Professor
Coverage
1. What is money?
2. The evolution of money and forms- Barter, Commodity money, Paper money, Bank
deposits.
3. The functions of money (a) Money as a medium of exchange (b) Money as a
measure of value (c) Money as a store of value (d) The standard of Deferred
payments.
4. The determinants of demand for money
5. The supply of money and the sources of money supply
6. Central bank and high powered money
7. Measurement of high powered money
8. Purpose of measuring money supply
2
Coverage..
9. The Keynesian demand for money function (a)The transaction demand for
money(b) the Precautionary demand for money (c) The speculative
demand for money
10.The Keynesian theory of interest rate,
11.Components of the money supply- M1, M2, M3 and M4
12.Measurement of the money supply
13.Implications of the money supply
14.Money Multiplier Approach
15.Role of Banking systems and creation of money
3
Coverage…
16.Determinants of the money supply
17.How the interest rate is determined?
18.Real Vs. Nominal interest rates
19.Liquidity
20.How do changes in money supply affect the economy?
21.Negative Interest rates and its implications on an economy.
4
What is money?
1. Money is primarily a medium of exchange or means of exchange
2. Money is the stock of assets that can be readily used to make
transactions.
3. Money is whatever is accepted in exchange
4. There is no commonly acceptable definition of money
Two procedures of Definition:
◦ 1. Nominalist - Attaches labels to real world objects.
◦ 2. Empiricist - Attaches labels to concepts and then search for the
corresponding real world entity.
5
Money Functions
Medium of Measure of value Standard of Store of value
exchange Deferred Payment
1. A medium of 1. Money is the basic unit for 1. Acts as a standard of 1. Money can be
exchange. Money measuring economic value deferred payment. used to hold
is used to pay for 2. This simplifies comparisons 2. Money is used in long- wealth
goods and services, of prices, wages, and term transactions; you 2. Most people use
and enables us to incomes might borrow $100 money only as a
avoid the “double 3. The unit-of-account function from a friend, for store of value for
coincidence of is closely linked with the example, and promise a short period
wants” required in a medium-of-exchange to pay him back $105 and for small
barter economy. function at a later date. amounts,
4. But countries with very high because it earns
inflation may use a different less interest
unit of account, so they don't than money in
have to constantly change the bank
prices
6
The Evolution of Money
Paper Crypto-
Coins currency
Gold, Silver
Metals and Copper
coins
Commodity
Money
Cattle, Salt, Cowry,
Barter yarn balls, skeins
and fabrics
the exchange
of
merchandise
for
merchandise
7
The Four Different Types of Money
Commodity Fiat Money Fiduciary Money Commercial
Money Bank Money
Its value is Fiat money gets its value Fiduciary money depends Commercial bank
defined by the from a government order for its value on the money is created
intrinsic value of (i.e. fiat). The word fiat confidence that it will be through what we
the commodity means the “command of generally accepted as a call fractional
itself. the sovereign”. That medium of exchange. reserve banking.
In other words, means, the government Unlike fiat money, it is not Fractional reserve
the commodity declares fiat money to be declared legal tender by the banking describes a
itself becomes legal tender, which government, which means process where
the money. It has requires all people and people are not required by commercial banks
intrinsic value. firms within the country to law to accept it as a means give out loans worth
Example: gold, accept it as a means of of payment. Instead, the more than the value
silver, copper payment. It has no issuer of fiduciary money of the actual
and other intrinsic value. Example: promises to exchange it currency they hold.
valuable the paper currency we use back for a commodity or
commodities fiat money.
8
Commodity Money
9
Commodity Money
10
Commodity Money
Cow Salt Cowry
11
Ancient Coins
12
Gold, Silver, and Copper
13
Paper Money
14
Indian Currency
15
16
Demand for Money
▪Demand for money refers to the desired holding of financial assets in the form of
money: that is, cash, checking accounts, and closely related assets, rather than
investments.
▪Keynes suggested three different motives:
1. The transactions motive. We wish to avoid having to cash in another asset
every time we make a purchase. (Imagine what a nuisance that would be!)
2. The precautionary motive. “Just in case.” We never know our spending
plans exactly; it pays to keep a little extra money around in case the urge for
a hot fudge sundae hits at a time when your stockbroker is playing golf and
cannot liquidate any of your assets.
3. The speculative motive. While money doesn’t have a very high return, it is
less risky than other assets. Speculative demand for money is actually
demand for a safe asset.
17
Macroeconomic Determinants of Money Demand
Determinant’s increase Causes Money Demand to
Price level Rise proportionately
Real Income Rise less than proportionately
Real Interest Rate Fall
Expected Inflation Fall
Nominal Interest Rate Rise
Wealth Rise
Liquidity of alternate assets Fall
Efficiency of Payment Technologies Fall
18
The Money Demand Function
The money demand function
◦Md = P*L(Y, i ) (Eq.1)
◦ Md is nominal money demand (aggregate)
◦ P is the price level
◦ L is liquidity preference function
◦ Y is real income or output
◦ i is the nominal interest rate on nonmonetary assets
◦ As discussed above, nominal money demand is proportional to the price
level
◦ A rise in Y increases money demand; a rise in i reduces money demand
The Money Demand Function..
We can write the nominal rate of interest as the following:
i = r + πe
I = nominal interest rate
r = expected real rate of interest
πe = expected inflation rate
Then we rewrite the Money demand function as:
Md = PL (Y, r + πe)
20
The Demand for Money: The Classical and the Keynesian Approach
The Classical Approach: The Keynesian Approach:
In Fisher’s “Equation of Keynes in his General Theory used a new term “liquidity preference” for the
Exchange”: MV=PT demand for money. Keynes suggested three motives which led to the demand
for money in an economy:
Where (1) the transactions demand,
M is the total quantity of money, (2) the precautionary demand,
V is its velocity of circulation, (3) the speculative demand.
P is the price level, and
T is the total amount of goods According to Keynes,
and services exchanged for (1) money held for transactions and precautionary purposes is primarily a
money. function of the level of income, LT = f (Y).
(2) the speculative demand for money is a function of the rate of interest,
MV represents the supply of Ls = f (r).
money. Thus the total demand for money is a function of both income and the interest
PT represents the demand for rate: LT + LS = f (Y) + f (r)
money. or L = f (Y) + f (r)
or L=f (Y, r) where L represents the total demand for money.
21
Liquidity Trap
Liquidity Preference curve or
A liquidity trap is a situation in which interest rates are low Money Demand curve
and savings rates are high, rendering monetary policy
ineffective.
Liquidity trap is a state when expansionary monetary policy
(increase in money supply) fails to increase the interest
rate, income and hence does not stimulate economic
growth.
Figure: Keynes pointed out that during depression when the
rate of interest is very low, the demand curve for money (or
the liquidity preference curve) becomes completely elastic
(horizontal). The rate of interest has fallen enough. It
cannot fall further.
There is a liquidity trap at short term zero percent interest
rate. When interest rate is zero, public would not want to
hold any bond, since money, which also pays zero percent
interest, has the advantage of being usable in transactions.
22
Money Equilibrium
It occurs at the interest rate at which the quantity of money demanded is equal to the
quantity of money supplied.
23
Equation of Exchange
▪The Equation of Exchange addresses the relationship between money and price level, and
between money and nominal GDP.
The equation simply states: MxV=PxY

Where M = the money supply, usually the M1
V = the velocity of money
P = the price level
Y = real output, or real GDP.
▪Velocity is the number of times the average dollar is spent to buy final goods and
services in a given year. Velocity can be calculated by using V = (P x Y ) / M
▪This equation demonstrates a direct relationship between price and money supply. If V
and Y are constant, a certain percentage change in money supply will cause a same
amount of change in the price level.
24
Money Supply..
▪The money supply is the quantity of money available in the economy.
▪Definition: The total stock of money circulating in an economy is the money
supply. The circulating money involves the currency, printed notes, money
in the deposit accounts and in the form of other liquid assets.
The money supply depends on the:
(1) Monetary Base; (2) Currency-deposit Ratio: (3) Reserve Ratio
The Central Bank of a country can control the money supply with:
(1) Open market operations;
(2)The reserve requirement;
(3) The discount rate;
(4) Interest on reserves
25
Monetary Base
The Monetary Base and
the Money Supply:
The monetary base is equal to
bank reserves plus currency in
circulation.
It is different from the money
supply, consisting mainly of
checkable or near-checkable
bank deposits plus currency in
circulation.
Each Rupee of bank reserves
backs several Rupees of bank
deposits, making the money
supply larger than the
monetary base.
26
A Model of the Money Supply
1. Monetary base, B =C+R
(controlled by the central bank; C=currency; R=Reserves)
2. Reserve-deposit ratio, rr = R/D
(depends on regulations & bank policies; rr=reserve ratio;
D=Deposits )
3. Currency-deposit ratio, cr = C/D
(depends on households’ preferences)
27
Statement on Money Supply - India
Year-on-year
(Amount in ₹ billion) 2018 2018 October 27, 2017 October 26, 2018
Mar 31 Oct 26 Amount % Amount %
M3 139625.9 144262.4 7504.1 6.1 13109.3 10.0
Components (i+ii+iii+iv)
i) Currency with the Public 17597.1 18751.3 -1536.5 -9.0 3265.7 21.1
ii) Demand Deposits with Banks 14837.1 13503.2 2133.3 20.5 964.5 7.7
iii) Time Deposits with Banks 106952.6 111762.1 6842.0 7.1 8858.1 8.6
iv) `Other ' Deposits with Reserve Bank 239.1 245.8 65.2 40.9 21.0 9.3
Sources (i+ii+iii+iv-v)
i) Net Bank Credit to Government Sector (a+b) 40014.0 42930.4 3029.6 8.1 2637.3 6.5
a) Reserve Bank 4759.6 6510.7 -1549.8 - 1587.9
b) Other Banks 35254.4 36419.8 4579.4 14.9 1049.4 3.0
ii) Bank Credit to Commercial Sector (a+b) 92137.2 96234.7 5099.2 6.4 11678.2 13.8
a) Reserve Bank 140.3 92.3 8.2 10.5
b) Other Banks 91996.9 96142.4 5091.0 6.4 11667.8 13.8
iii) Net Foreign Exchange Assets of Banking Sector 29223.0 29949.7 862.3 3.3 2723.0 10.0
iv) Government's Currency Liabilities to the Public 256.5 257.0 20.2 8.6 1.6 0.6
v) Banking Sector's Net Non-Monetary Liabilities 22004.8 25109.4 1507.3 7.7 3930.8 18.6
of which : Net Non-Monetary Liabilities of R.B.I. 9069.9 11492.6 -203.0 -2.2 2609.3 29.4
28
Money Supply Measures
Reserve Money (M0) Narrow Money M2 Broad Money (M3) M4
(narrowest money) (M1)
= Currency in circulation Currency with the M1 + Savings M1+ Time deposits with M3 + All
+ Bankers’ deposits with public + deposits of the banking system = deposits with
the RBI + ‘Other’ deposits Demand deposits post office Net bank credit to the post
with the RBI with the savings banks Government + Bank office savings
= Net RBI credit to the banking system + credit to the commercial banks (excluding
Government + RBI credit to ‘Other’ deposits sector + Net foreign National Savings
the commercial sector + with the RBI. exchange assets of the Certificates).
RBI’s claims on banks + banking sector +
RBI’s net foreign assets + Government’s
Government’s currency currency liabilities to the
liabilities to the public – public – Net non-
RBI’s net non-monetary monetary liabilities
liabilities of the banking sector
29
Two Types of Money
Ordinary Money (M) High Powered Money (H)
Ordinary money (M) is High powered money (H) is the money
referred to as currency plus produced by the RBI and the
demand deposits: government of India (small coins
M = C + dd. including one rupee notes) held by the
public and banks.
30
High Powered Money
High powered money or powerful money is the currency that
has been issued by the Government and Reserve Bank of
India.
Some portion of this currency is kept along with the public
while rest is kept as funds in Reserve Bank.
H=C+R
Where H = High Powered Money
C = Currency with the public (Paper money + coins)
R = Government and bank deposits with RBI
31
Money Multiplier
It is the relationship between monetary base and money supply in
economy. The amount of money that banks generate with each unit (Rs
in case of India) of money.
The money multiplier is the reciprocal of the reserve ratio. The money
multiplier is the ratio of deposits to reserves in the banking system.
The Money Multiplier, m is the increase in the money supply resulting

from a one-rupee increase in the monetary base.
32
Determinants of Money Supply..
▪The determinants of money supply are both exogenous

and endogenous which can be described broadly as:
1. The minimum cash reserve ratio
2. The level of bank reserves
3. The desire of the people to hold currency relative to
deposits
▪The last two determinants together are called the monetary base
or the high powered money..
33
How do changes in money supply
affect the economy?
Direct effect Indirect effect
Monetarist view: Money affects the economy via interest
Increase in money rates:
balances affects R affects Expenditure (C and I)
consumption Exchange Rates (and therefore X and M)
directly
Property Prices
Bonds and Shares
34
How Banks Create Money?
First Step Second Step Third Step
1. The central bank 1. The bearer deposits 1. Banks lend a portion
creates money by the currency in a of their deposits
simply printing chequing account at keeping the balance
currency and the bank. as reserves.
exchanging it for 2. The bank holds your 2. Reserves are cash and
bonds. money and keeps deposits a bank keeps
2. Currency is a financial track of it until you on hand, or at the
asset to the bearer write a cheque. central bank, enough
and a liability to the to manage the normal
central bank. cash inflows and
outflows.
35
Banks’ Role in the Monetary System
No banks 100-percent- Fractional-reserve banking
reserve banking
Early periods of A system in which A system in which banks hold a fraction of their
civilization when no banks hold all deposits deposits as reserves.
banks existed in as reserves. Original deposit = $1000
+ First bank lending = $ 800
formal sense. Before a deposit:
+ Second bank lending = $ 640
With no banks, D=0; C=M + Third bank lending = $ 512
M=C+D After a deposit: + other lending…
D = 0 and M = C D=M; C=0 Total money supply = (1/rr ) × $1,000. where rr = ratio of
D=Deposits 100%-reserve banking has reserves to deposits In our example, rr = 0.2, so M = $5,000
C=Currency no impact on size of A fractional-reserve banking system creates
M=Money supply money supply. money, but it doesn’t create wealth:
Bank loans give borrowers some new money
and an equal amount of new debt.
36
The Instruments of Monetary Policy
Open Market Discount Rate Reserve Interest on
Operations or Repo Rate Requirements Reserves
The Central Bank’s The interest rate Central bank’s The central bank
preferred method of the central bank regulations that pays interest on bank
monetary control. charges on loans to impose a minimum reserves deposited
1. To increase the banks reserve-deposit ratio. with it.
base, the central 1. To increase the E.g. CRR and SLR in 1. To reduce the
bank (RBI in base, the India reserve-deposit
India) could buy central bank 1. To reduce the ratio, the Fed
government could lower the reserve-deposit could pay a lower
bonds, paying discount rate, ratio, the central interest rate on
with new Rupees. encouraging bank could reduce reserves.
banks to borrow reserve
more reserves. requirements.
37
Nominal vs. Real Interest Rate
Nominal Interest Rate Real Interest Rate
1. Nominal interest rate refers to the interest 1. The real interest rate is the rate of interest
rate before taking inflation into account an investor, saver or lender receives (or
expects to receive) after allowing for
2. Nominal Interest Rates tend to be
inflation.
Procyclical and lagging
2. Real interest rate is adjusted for changes in
3. Interest rates tend to be negatively
price level so it more accurately reflects the
correlated with changes in money (in the
cost of borrowing
short run)
3. Ex ante real interest rate is adjusted for
4. Interest rates are highly correlated with
expected changes in the price level
Inflation rates (less so for longer term rates)
4. Ex post real interest rate is adjusted for
actual changes in the price level
38
The Determination of the Interest Rates
i is determined by Money Demand (MD) & Money Supply
(MS)
1. Central bank changes i by changing MS
2. Central bank changes MS with open market operations
3. Buying bonds increases the MS and reduces i
4. Selling bonds decreases the MS and increases I
◦ Increases in Central Bank money (central bank buys bonds) decrease the
interest rate
◦ Decreases in Central Bank money (central bank sells bond) increase the
interest rate
39
The Determination of the Interest Rates..
In the Figure, Ms is insensitive to Ms
interest rate r.
(Money Supply)
At any point above E, the r will be
higher. Md
Md = Mt + Mp + Msp (Money Demand)
Where, Mt is the money
demanded for transaction motive,
E Md=Ms
Mp is the money demanded for r
precautionary motive,
Msp is the money demanded for
speculative motive
O
DR. VIGHNESWARA SWAMY 40
Setting Interest Rates
What does the central bank take into account in setting interest rates?
1. Forecasts of inflation
2. Spare productive capacity
3. Growth of retail sales
4. Trends in output growth relative to growth of
5. productive capacity
6. Growth of money supply
7. House price changes
8. Interest rate trends in USA, EU and japan
9. Exchange rate trends
41
Negative Interest Rates
▪Negative interest rates mean depositors pay money to save their money, a
reversal of the normal rules of economics.
▪Negative rates are the opposite—savers who do not want to spend their funds are
willing to pay borrowers to accept them.
▪In theory, nominal rates should never be negative because investors are better off
holding currency, which earns a zero nominal rate, instead.
▪In practice, holding large sums of currency incurs a convenience cost—it is bulky
and can be lost or stolen. Buying a safe or renting a security deposit box are
examples of costs associated with holding currency.
▪ Riskless negative rates can go at least low enough to equal the convenience cost
of holding currency.
▪ In countries with negative rates, banks instead pay to deposit reserves at their
central bank
42
What sort of countries have negative rates?
1. Countries with ultra-low inflation or deflation, meaning

falling prices associated with weak economic growth resort
to negative interest rates.
2. The European Central Bank, which oversees monetary policy

for countries that use the euro, introduced negative rates in
2014.
3. Japan’s central bank followed in January, announcing that it

would charge commercial banks a fee of 0.1 percent on a
portion of their reserves that they keep with it.
43
What is Liquidity?
1. Liquidity means how quickly you can get your hands on your cash. In simpler
terms, liquidity is to get your money whenever you need it.
2. The ability to trade immediately and at prices that are only affected by expected
return and risk considerations
1. Market liquidity: ability to transform financial assets into cash at current market prices
2. Balance sheet liquidity: cash holdings
3. Funding liquidity: ability to convert assets into cash
4. Macroeconomic liquidity: the availability of cash in the economy
Motives for Liquidity preference:

Liquidity preference of a particular individual depends upon several considerations. The desire for
liquidity arises because of three motives: (i) The transactions motive; (ii) The precautionary motive
and; (iii) The speculative motive.
44
Linking the Different Concepts of Liquidity
45
Liquidity Trap
Liquidity trap is a situation when expansionary monetary policy
(increase in money supply) does not increase the interest rate,
income and hence does not stimulate economic growth.
Liquidity trap refers to a situation where the interest rates in an
economy are at extremely low levels, and individuals prefer to
hold their money in cash or cash equivalent form as they are
uncertain about the performance of a nation’s economy.
Liquidity traps occur when a country is trying to recover from a
recession, and the government aims to boost the investment in
the nation by reducing interest rates to facilitate borrowing.
A Liquidity Trap is an economic situation where everyone
hoards money instead of investing or spending it. It occurs when
interest rates are zero or during a recession. People are too
afraid to spend so they just hold onto the cash. As a result,
central banks use of expansionary monetary policy doesn't
boost the economy.
46
Liquidity Trap
A liquidity trap is an
economic situation
where everyone hoards
money instead of
investing or sending it.
It occurs when interest
rates are zero or during
a recession. People are
too afraid to spend so
they just hold onto the
cash. As a result,
central banks use of
expansionary monetary
policy doesn't boost
the economy
47
Keywords
1. Money
2. Commodity Money
3. Paper Money
4. Money Demand
5. Keynesian Money Demand Function
6. Money Supply – M1, M2, M3, M4
7. Central Bank
8. Ordinary Money
9. High Powered Money
10. Money Multiplier
11. Money Creation
12. Fractional Reserve Banking
13. Interest Rates
14. Real Vs. Nominal Interest Rates
15. Liquidity
16. Negative Interest Rates
48
Price Stability
Professor
Coverage
1. Inflation Vs. deflation
2. Measures of inflation
3. Types of inflation
4. Low inflation
5. Galloping inflation
6. Hyperinflation
7. Threshold inflation
8. Demand-pull Vs. Cost-push inflation
9. Stagflation
10. Expected Vs. unexpected inflation
11. Core inflation Vs. Headline inflation,
2
Coverage..
11. The role of government and RBI to control inflation
12. Economic impacts of inflation
13. Is a little inflation is good for the economy?
14. Price in the AD-AS framework
15. The Phillips curve
16. Short run Philips curve and Long run Philips curve.
3
Inflation
Inflation is a pervasive and general rise in the average price level.
Inflation is an increase in the average level of prices, and a price is the
rate at which money is exchanged for a good or service.
Inflation measures how much more expensive a set of goods and
services has become over a certain period, usually a year.
Deflation is a fall in the overall level of prices.
Rate of Inflation shows the rate of change of prices over time.
Rate of inflation is the percentage rate of change in a price index
Rate of inflation = (PI2 – PI1) / PI1
4
Deflation
▪Deflation is the opposite of inflation.
▪Deflation is the fall in prices. It occurs when the inflation rate falls below 0%. When this
happens, the nominal prices of goods are falling on average and the purchasing power of
money is increasing.
▪Deflationary Spiral is a situation where decreases in price lead to lower production, which
in turn leads to lower wages and demand, which leads to further decreases in price.
▪It is generally caused when an asset bubble bursts.
▪Deflation can turn a recession into a depression.
▪During the Great Depression of 1929, prices dropped 10 percent a year. Once deflation
starts, it is harder to stop than inflation.
5
Measures of Inflation
Price index level
▪Expresses the level of prices of goods traded in economy at the same
time
▪Price index is calculated for particular market basket for examined
periods.
The change of price index level within time is the rate of inflation.
1. Consumer price index
2. Producer price indexes
3. Wholesale price indexes
4. Commodity price indexes
6
Illustration
If your income goes up from $30,000 to $35,000 and
inflation is 8%, are you better or worse off?
Ans:
Take the difference and divide by the original number
$5,000/$30,000 = 16.7%
You are better off because your real income has
increased by 16.7-8=8.7%
7
Consumer Price Index (CPI)
The CPI measures the price increases of a particular basket of goods and services.
(1) Selection of the Base Year (CPI = 100)
(2) Selection of CPI basket, Example of Consumer Basket, weightage (to measure the
importance of one item in the basket)
(3) Collection of data on prices
(4) Calculation of CPI
Weighted CPI
The rate of inflation is determined as:
8
Wholesale Price Index
▪Wholesale price index is a measure of changes in the prices
charged by manufacturers and wholesalers.
▪Wholesale price indexes measure the changes in commodity
prices at a selected stage or stages before goods reach the retail
level; the prices may be those charged by manufacturers to
wholesalers or by wholesalers to retailers or by some
combination of these and other distributors.
9
Types of Inflation
From the quantitative point of view
Creeping
Galloping inflation Hyperinflation
inflation
The slow but The rate of inflation It is inflation that is "out of control", a
steady increase in exceeds the rate of condition in which prices increase rapidly as a
prices. production growth, currency loses its value. Hyperinflation is over
The rate of inflation Galloping inflation is 100% per year. Prices as well as wages are
doesn’t exceed the from 10% to 100%. extremely erratic. Money have no value and
rate of production Money looses barter trade emerges (barter means the
growth. Creeping purchase power, exchange of good for good). Example:
inflation is < 10% people hold as little Germany after I.WW, Hungary after II.WW.,
money as possible. Zimbabwe, Venezuela
10
Types of Inflation..
Open
Suppressed inflation Hidden inflation
inflation
If economic If state authorities damp or even Government imposes strict controls
imbalance is stop the rise of price level by to curb price inflation, producers
accompanied with administrative means. Such are forced to sell the products at
rising price level. situation is followed by existence the prices required.
of scarce commodities, shadow Producers can not sell the
economy etc. commodity at higher prices to get
In such cases the provision of the profit, therefore, lower on the
basic necessities such as quality of products. This means
agricultural products is set by the that employers are selling lower
government by introducing price quality products at higher prices ->
controls on commodities inflation is hidden.
11
Types of Inflation..
Chronic Low Inflation Walking Inflation
Inflation
Chronic inflation Low inflation (no rapid rise) Walking inflation is a type of strong, or
occurs when inflation contributes towards economic pernicious, inflation is between 3-10 percent
steadily increases for stability – which encourages saving, a year.
a long time investment, economic growth, and It heats up economic growth too fast. People
helps maintain international start to buy more than they need, just to
competitiveness. avoid tomorrow's much higher prices.
Generally the governments target an This drives demand even further so that
inflation rate of around 2-4%. This suppliers can't keep up. More important,
moderate but low rate of inflation is neither can wages.
considered the best compromise As a result, common goods and services are
between avoiding the costs of priced out of the reach of most people.
inflation but also avoiding the costs
of deflation
12
Types of Inflation…
Wage Inflation Asset Inflation
Wage inflation is when workers' pay rises fasterAsset inflation occurs in any asset class
than the cost of living. This occurs in three when the asset prices experience high
situations. First, is when there is a shortage of
levels of price rise.
workers. Second, is when labor unions negotiate Good examples are housing, oil and
ever-higher wages. Third is when workers gold.
effectively control their own pay. It is generally overlooked by the central
banks and other inflation-watchers
Of course, everyone thinks their wage increases when the overall rate of inflation is low.
are justified. But higher wages are one element But the subprime mortgage crisis and
of cost-push inflation. That can drive up the subsequent global financial crisis
prices of a company's goods and services. demonstrated how damaging unchecked
asset inflation can be.
13
Core Inflation Vs. Headline Inflation
Core Inflation Headline Inflation
1. An inflation measure which excludes transitory or 1. Point-to-point changes in the wholesale price index
temporary price volatility as in the case of some (WPI) were considered the headline inflation rate.
commodities such as food items, energy products etc. It 2. The WPI is a weighted average of the prices of most
reflects the inflation trend in an economy. goods produced in the economy, with the weights being
2. Core means, we should ignore food and fuel part. their shares in domestic output and their prices those
3. Core inflation = Only WPI of Non-food manufacturing prevailing in wholesale markets.
industries= Headline WPI – (primary + fuel + food mfg. 3. Headline inflation is your general index like WPI (for
industries) India), CPI etc. that includes all the items used for
4. A dynamic consumption basket is considered the basis measuring inflation.
to obtain core inflation. Some goods and commodities 4. Headline inflation tends to revert strongly towards core
have extremely volatile price movements. Core inflation inflation over a time period making the case for core
is calculated using the Consumer Price Index (CPI) by stronger.
excluding such commodities.
5. Core inflation index excludes a certain items whose
prices are more volatile and hence may not represent a
true picture of the inflation.
14
Inflation vs. Disinflation
Assume the following Inflation Disinflation
annual price levels as
compared to the prices in As the economy Between 2013 and 2015, the rise in price
2012: moves through levels slows down. Between 2013 and
2012 to 2015, 2014, the price level only increases by two
2012: 100% of 2012 prices there is a percentage points, which is lower than the
2013: 104% of 2012 prices continued growth four percentage point increase between
in the price level. 2012 and 2013. The trend continues
2014: 106% of 2012 prices
This is an between 2014 and 2015, where there is
2015: 107% of 2012 prices example of only a one percentage point increase. This
2016: 105% of 2012 prices inflation; the is an example of disinflation; the overall
price level is price level is rising, but it is doing so at a
continually rising. slower rate.
15
Stagflation
▪Stagflation occurs when economic growth is stagnant but there still is price inflation.
▪This seems contradictory, if not impossible.
▪Why would prices go up when there isn't enough demand to stoke economic
growth?
▪Stagflation occurs when the prices of goods rise while unemployment increases and
spending declines.
▪It happened in the 1970s when the United States abandoned the gold standard.
Once the dollar's value was no longer tied to gold, it plummeted. At the same time,
the price of gold skyrocketed.
▪Stagflation is also considered an unnatural phenomenon since inflation shouldn't
happen when an economy is weak.
16
Threshold Inflation
▪Threshold level of inflation can be described as that
inflexion point beyond which the output growth is not
optimal.
▪Empirical studies have shown that at inflation rates higher
than threshold level, the output growth has retarded.
▪The threshold inflation rate is within 4 to 4.5 per cent for
India. Beyond this level, inflation is growth retarding.
17
Causes of Inflation
Cost-push inflation Built-in inflation (or
Demand-pull inflation
(or supply-shock) Anticipated inflation)
Arises when aggregate demand in an It is a type of inflation It is induced by adaptive
economy outpaces aggregate supply. caused by large increases expectations, often linked to
It involves inflation rising as real gross in the cost of important the "price/wage spiral“
domestic product rises and goods or services where It involves workers trying to
unemployment falls. This is commonly no suitable alternative is keep their wages up with
described as "too much money chasing available. prices and then employers
too few goods". Possible causes of cost- passing higher costs on to
Possible causes of demand-pull inflation: push inflation: (i) consumers as higher prices as
(i) Excessive investment expenditures; (ii) Imperfect competition; (ii) part of a "vicious circle.“
Excessive growth of consumption Increased taxes; (iii) Rising Built-in inflation reflects
expenditures; (iii) Low-cost loans; (iv) Tax wages; (iv) Political events in the past, and so
cutting; (v) Augmentation of government incidents (like oil crises) might be seen as hangover
expenditures inflation.
18
Effects of Inflation
Redistribution Social Impact of
Impact on Economy Balance
Effect of Inflation Inflation
• Inflation affects recipients • Socially poor persons • Fall of real product bellow potential product
of fixed income firstly suffer from inflation • Changes in the structure of consumption
(nominal incomes remain more then rich (consumers are buying cheaper goods)
same but the real value of • In case of fixed currency exchange rate higher
income drop) exports are incited.
• Inflation affects the • Inflation deforms prices
purchasing power of • Inflation causes higher costs and makes economy
wages that don’t follow less efficient
the rise of prices • Creeping and anticipated inflation has positive
• Inflation causes effect on economy and stimulates economic
diminishing value of loans growth
and savings • High inflation and not anticipated inflation are
serious problems in economy.
19
Expected vs. Unexpected Inflation
1. Expected inflation 1. Unexpected inflation
1. Expected inflation is the 1. Unexpected inflation is the inflation experienced that
inflation that economic is above or below that which we expected.
agents expect in the future. 2. Unexpected inflation redistributes wealth from
2. Wage negotiations and creditors to debtors.
pricing adjustments in the 3. When unexpected inflation is higher than expected,
businesses can help solve the borrowers tend to benefit.
this problem of expected 4. When the unexpected inflation is lower than
inflation. expected, lenders tend to benefit.
3. Expected inflation can give 5. Unexpected inflation can give rise to inequality,
rise to menus costs and information asymmetry, and risk premium.
shoe-leather costs.
20
Hyperinflation
▪Definition: Hyperinflation is a rapid and often uncontrollable currency devaluation causing
the prices of goods and services to skyrocket in a short period of time.
▪Although there is no precise threshold for hyper-inflation, normally it describes an inflation
rate that exceeds 50 percent.
▪Hyperinflation is usually caused by an extremely rapid growth in the money supply of an
economy. When the monetary and fiscal policy allow the issuance of “new” money to
accommodate for government spending, the money supply grows faster than the real
output of the economy, thus causing inflation.
▪Hyperinflation refers to a period of massive price rise.
▪Prices grow so rapidly that the payment system is damaged to the point of shutdown
▪Too much money has been printed → outward push of AD dominates all else in our
macroeconomic models 21
The role of government and RBI to control inflation
The main policy tools to control inflation include:
1. Monetary policy – Setting interest rates. Higher interest rates reduce
demand, leading to lower economic growth and lower inflation
2. Control of money supply – Monetarists argue there is a close link between
the money supply and inflation, therefore controlling money supply can
control inflation.
3. Supply-side policies – policies to increase competitiveness and efficiency of
the economy, putting downward pressure on long-term costs.
4. Fiscal policy – a higher rate of income tax could reduce spending and
inflationary pressures.
5. Wage controls - Trying to control wages could, in theory, help to reduce
inflationary pressures. However, apart from the 1970s, rarely used.
22
Economic impacts of inflation
1. Inflation can cause unemployment when the uncertainty of inflation leads to
lower investment and lower economic growth in the long term.
2. Inflationary growth is unsustainable leading to a boom and bust economic cycle.
3. Inflation leads to decline in competitiveness and lower export demand, causing
unemployment in the export sector (especially in a fixed exchange rate).
4. There is no direct link between unemployment but often we see a trade-off e.g. in
a period of strong economic growth and falling unemployment, we see a rise in
inflation.
5. A period of high and volatile inflation discourages firms from investing. Because
inflation is high, firms are less certain investment will be profitable.
23
Is a little inflation is good for the economy?
A little inflation (around 3-5%) is always considered as good for overall growth of economy. Some of
the reasons for the same are as following:
1. The consumer always expects the prices of goods to increase, so they spend more frequently,
which increases demand and provide profitability to the manufacturers.
2. A little inflation is a sign of growing and healthy economy.
3. Inflation always works as a lubricant for any shock to economy and help it to recover. For
example in a recession time cutting wages are considered more profitable than cutting jobs,
but the earlier is not accepted easier than the later, and as we know job cuts are always bad
for economy. But if there’s inflation in economy, employers just need to provide lesser raise
than inflation rate and no one would mind.
4. Inflation drives people to invest their money, instead of locking them up, because each day
reduces the purchasing power of money and it’s better to invest than loose purchasing
power.
5. Investment helps companies or government to raise money for growth easier.
24
Is a little inflation is good for the economy?
1. A small amount inflation reduces the natural rate of unemployment
2. It provides a necessary mechanism for lowering the real wages
without cutting the nominal wages.
25
The Phillips
Curve
In 1958 A.W. Phillips published a
study of wage behavior in the U.K.
between 1861 and 1957
The main findings are summarized
in Figure.
1. There is an inverse relationship
between the rate of
unemployment and the rate of
increase in money wages
2. From a policymaker’s
perspective, there is a trade-off
between wage inflation and
unemployment
26
The Phillips
Curve..
▪The curve sloped down from left to
right and seemed to offer policy
makers with a simple choice
▪You have to accept inflation or
unemployment. You cannot lower
both.
▪The Phillips curve is a dynamic
representation of the economy; it
shows how quickly prices are rising
through time for a given rate of
unemployment.
▪The relationship between inflation
and unemployment depends upon
the time frame
27
Short-run Phillips curve
Short-run Phillips curve is a curve that shows
the relationship between the inflation rate
and the unemployment rate when the
natural unemployment rate and the
expected inflation rate remain constant.
In the Figure:
1. The natural unemployment rate is 6 percent.
2. The expected inflation rate is 3 percent a year.
3. This combination, at point B, provides the anchor
point for the short-run Phillips curve.
4. The short-run Phillips curve passes through points
A, B, and C and is the curve SRPC.
28
The Long-Run Phillips Curve
▪The long-run Phillips curve is a vertical line
that shows the relationship between
inflation and unemployment when the
economy is at full employment.
▪The long-run Phillips curve is a vertical line
at the natural unemployment rate.
▪In the long run, there is no unemployment-
inflation trade-off.
▪In the long run, the only unemployment rate
available is the natural unemployment rate,
but any inflation rate can occur.
29
Why is Phillips Curve so Important?
1. The Phillips curve focuses directly on two policy targets: the
inflation rate and the unemployment rate.
2. The aggregate supply curve shifts whenever the money wage rate
or potential GDP changes, but the short-run Phillips curve does
not shift unless either the natural unemployment rate or the
expected inflation rate change.
30
Keywords
Inflation
Deflation Demand-pull and Cost-push inflation
Disinflation Expected and Unexpected inflation
Hyperinflation Consumer price index
Threshold inflation Phillips Curve
Stagflation Unemployment
Core inflation Natural employment
Headline Inflation Supply shocks
31
Monetary Policy
Professor
Monetary Policy
▪Monetary policy is the macroeconomic policy laid down by the
central bank.
▪Monetary policy is the management of money supply and
interest rates by central banks to control prices and
employment.
▪It involves management of money supply and interest rate
▪It is the demand side economic policy used by the government
of a country to achieve macroeconomic objectives like inflation,
consumption, growth and liquidity.
2
Monetary Policy: Characteristics
Goals
Intermediate Monetary Instruments

Targets Policy
Objectives
Monetary Policy Committee (MPC)
▪Section 45ZB of the amended RBI Act, 1934 also provides for an empowered six-
member monetary policy committee (MPC) to be constituted by the Central
Government .
▪The MPC determines the policy interest rate required to achieve the inflation target.
▪The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating
the monetary policy. Views of key stakeholders in the economy, and analytical work of
the Reserve Bank contribute to the process for arriving at the decision on the policy
repo rate.
▪The Financial Markets Operations Department (FMOD) operationalises the monetary
policy, mainly through day-to-day liquidity management operations.
▪The Financial Markets Committee (FMC) meets daily to review the liquidity conditions
so as to ensure that the operating target of the weighted average call money rate
(WACR). 4
Instruments of Monetary Policy
1. Repo Rate 6. Bank Rate
2. Reverse Repo Rate 7. Cash Reserve Ratio (CRR)
3. Liquidity Adjustment Facility (LAF) 8. Statutory Liquidity Ratio (SLR)
4. Marginal Standing Facility (MSF) 9. Open Market Operations (OMOs)
5. Corridor 10. Market Stabilisation Scheme (MSS)
5
#1. Repo Rate
Repo Rate: The (fixed) interest rate at which the Reserve
Bank provides overnight liquidity to banks against the
collateral of government and other approved securities
under the liquidity adjustment facility (LAF).
6
#2. Reverse Repo Rate
Reverse Repo Rate: The (fixed) interest rate at which the
Reserve Bank absorbs liquidity, on an overnight basis, from
banks against the collateral of eligible government securities
under the LAF.
7
#3. Liquidity Adjustment Facility (LAF)
▪Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well
as term repo auctions.
▪Progressively, the Reserve Bank has increased the proportion of
liquidity injected under fine-tuning variable rate repo auctions of range
of tenors.
▪The aim of term repo is to help develop the inter-bank term money
market, which in turn can set market based benchmarks for pricing of
loans and deposits, and hence improve transmission of monetary policy.
▪The Reserve Bank also conducts variable interest rate reverse repo
auctions, as necessitated under the market conditions.
8
#4. Marginal Standing Facility (MSF)
▪Marginal Standing Facility (MSF): A facility under which
scheduled commercial banks can borrow additional amount
of overnight money from the Reserve Bank by dipping into
their Statutory Liquidity Ratio (SLR) portfolio up to a limit at
a penal rate of interest.
▪ This provides a safety valve against unanticipated liquidity
shocks to the banking system.
9
#5. Corridor
▪Corridor: The MSF rate and reverse repo rate determine the corridor for the daily
movement in the weighted average call money rate.
▪An interest rate corridor or a policy corridor refers to the range within which the
operating target of the monetary policy - a short term interest rate, say the
weighted average call money market rate - moves around the policy rate
announced by the central bank.
▪The policy rate is set within a corridor charted by
◦ A standing collateralised marginal lending facility available throughout the
day at a rate higher than the Policy rate that provides the upper bound; and
◦ A standing uncollateralised deposit facility at a rate lower than the Policy rate
that provides the lower bound to the corridor.
10
#6. Bank Rate
▪Bank Rate: It is the rate at which the Reserve Bank is ready to buy or
rediscount bills of exchange or other commercial papers.
▪This rate has been aligned to the MSF rate and, therefore, changes
automatically as and when the MSF rate changes alongside policy repo rate
changes.
▪Bank rate is also called discount rate because
bank provide finance to the commercial bank
by rediscounting the bills of exchange.
▪When central bank raises the bank rate, the
commercial bank raises their lending rates, it
results in less borrowings and reduces money
supply in the economy.
11
#7. Cash Reserve Ratio (CRR)
▪Cash Reserve Ratio (CRR): The average daily balance that a bank is
required to maintain with the Reserve Bank as a share of such per
cent of its Net demand and time liabilities (NDTL) that the Reserve
Bank may notify from time to time in the Gazette of India.
▪Increase in the CRR leads to the contraction of credit
▪Decrease in the CRR leads to the expansion of credit and banks
tends to make more money available to borrowers.
▪Since 2006 there is no minimum or maximum level of CRR
12
#8. Statutory Liquidity Ratio (SLR)
▪Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is required to
maintain in safe and liquid assets, such as, unencumbered government
securities, cash and gold.
▪Changes in SLR often influence the availability of resources in the banking
system for lending to the private sector.
▪Increase in the SLR leads to the contraction of credit
▪Decrease in the SLR leads to the expansion of credit and banks tends to
make more money available to borrowers.
▪40% of total demand and time liabilities is the maximum SLR that can be
stipulated by RBI.
13
#9. Open Market Operations (OMOs)
▪Open Market Operations (OMOs): These include both, outright purchase and sale of
government securities, for injection and absorption of durable liquidity, respectively by
central bank of the country.
▪The sale of security by the central bank leads to contraction of credit and purchase there
of to credit expansion.
▪OMO is used to wipe out shortage/excess of Money in Money Market, to influence the
term and structure of interest rate and to stabilize the market for government securities.
▪When RBI sells securities in open market, commercial banks and public buy it. This reduces
the existing money supply as money gets transferred from the Commercial Banks to RBI.
▪When RBI buys securities from commercial banks in open market, commercial banks sell it
and get back the money they had invested in them, thereby increasing the existing money
supply.
14
#10. Market Stabilisation Scheme (MSS)
▪Market Stabilisation Scheme (MSS): This instrument for monetary
management was introduced in 2004.
▪Surplus liquidity of a more enduring nature arising from large capital
inflows is absorbed through sale of short-dated government
securities and treasury bills.
▪The cash so mobilised is held in a separate government account with
the Reserve Bank.
15
Qualitative Measures / Selective
Credit Control
1. Rationing of credit
2. Margin Requirement
3. Variable interest rates
4. Control Through Directives
5. Regulation of consumer credit
6. Moral Suasion
7. Direct Action
16
Expansionary Monetary Policy
At times of Recession and unemployment
Expansionary monetary
policy is monetary policy 1. OMO – buys
that increases aggregate securities Money supply Investment
demand. 2. CRR - reduced increases increases
Expansionary monetary
policy reduces the 3. Bank Rate -
interest rate by reduced
increasing the money
supply. This increases
investment spending Aggregate output
and consumer spending,
increases by a Aggregate
which in turn increases demand
aggregate demand and multiple of the
real GDP in the short increase in investment increases
run.
17
Expansionary
Monetary
Policy to Fight
a
Recessionary
Gap
18
Contractionary Monetary Policy
ContractionaryAt times of Inflation
monetary policy is
monetary policy
that reduces 1. OMO – sells securities
aggregate demand.
2. CRR & SLR - raised
Money supply Interest rate
Contractionary decreases
monetary policy 3. Bank Rate - raised
increases
raises the interest
rate by reducing the
money supply.
This reduces
investment
spending and
consumer Investment Aggregate demand
spending, which in expenditure declines declines Price level falls
turn reduces
aggregate demand
and real GDP in the
short run.
19
Contraction
ary
Monetary
Policy to
Fight an
Inflationary
Gap
20
Expansionary vs. Contractionary
monetary policy
Expansionary monetary policy is monetary policy that increases aggregate demand.
Contractionary monetary policy is monetary policy that reduces aggregate demand.
21
Inflation Targeting
1. Inflation targeting occurs when the central bank sets an explicit target for
the inflation rate and sets monetary policy in order to hit that target.
2. Public announcement of medium-term numerical target for inflation
3. Institutional commitment to price stability as the primary, long-run goal of
monetary policy and a commitment to achieve the inflation goal
4. Information-inclusive approach in which many variables are used in
making decisions
5. Increased transparency of the strategy
6. Increased accountability of the central bank
22
Inflation Targeting
Advantages
◦ Does not rely on one variable to achieve target
◦ Easily understood
◦ Reduces potential of falling in time-inconsistency trap
◦ Stresses transparency and accountability
Disadvantages
◦ Delayed signaling
◦ Too much rigidity
◦ Potential for increased output fluctuations
◦ Low economic growth during disinflation
23
Monetary Neutrality
▪Why economists believe in monetary neutrality — that monetary
policy affects only the price level, not aggregate output, in the long
run
▪In the long run, changes in the money supply affect the aggregate
price level but not real GDP or the interest rate.
▪In fact, there is monetary neutrality: changes in the money supply
have no real effect on the economy. So monetary policy is ineffectual
in the long run.
24
Impact of demonetization on interest rates
▪Demonetization forced the conversion of cash into less liquid
bank deposits which resulted in the rise of bank deposits.
▪The rise in the bank deposits further led to decline in the bank
lending rates.
▪This demonetization led to lower interest rates without
affecting inflation.
▪The lower lending rates created further demand for loans thus
boosting aggregate demand in the economy.
25
Impact of demonetization on Indian
economy
1. Demonetization led to the conversion of cash into less liquid bank
deposits.
2. Demonetization caused downward wage rigidity which led to
decline in output and employment.
3. Demonetization resulted in less borrowing by the firms.
4. Demonetization affected the households as they switched from
cash to non-cash forms of payments to overcome the impact of
cash shortage.
26
Key words
1. Monetary policy
2. Open market operation
3. Bank rate
4. Cash reserve ratio
5. Statutory liquidity ratio
6. Repo rate
7. Reverse repo rate
8. Marginal standing facility
9. Liquidity Adjustment Facility
10.Market Stabilization Scheme
27
Fiscal Policy
Professor
Coverage
1. Fiscal Policy
2. Objectives of Fiscal Policy
3. Types of Fiscal Policy
4. Discretionary Vs. Non-discretionary Fiscal Policy
5. Expansionary Vs. Contractionary Fiscal Policy
6. Fiscal instruments-Taxes, Public expenditure, Public borrowings.
7. Tax structure- Direct and Indirect tax.
8. Impact of GST on the Indian economy.
2
Coverage..
9. Role of Fiscal Policy during inflation and deflation
10.Laffer curve
11.Fiscal Policy and stabilization
12.Types of deficits
13.Public debt
14.Crowding-out effect.
3
Fiscal Policy
•Fiscal policy is the use of government taxes and spending to alter
macroeconomic outcomes.
•It is the manipulation of government purchases, transfer payments,
taxes, and borrowing in order to positively influence the economy
•Keynes argued that fiscal policies may be necessary to bring about full
employment
•Post World War experiences showed that government stimulus
package can work
•Examples of Fiscal policies are (i) Government purchases; (ii) Transfer
payments; (iii) Taxes
4
Objectives of Fiscal Policy
Fiscal Policy is designed to:
1) Achieve full-employment
2) Control inflation
3) Encourage economic growth
5
Goal #1 of Fiscal Policy: raise potential GDP
Supply-side economics
▪ taxes entail welfare loss
▪  tax rates on K and L incomes  enhanced incentives to invest and work
Implication: growth of permanent GDP= supply side phenomenon
 tax rates to be lowered to favor growth
Yet most people think that tax elasticity of investment and work
effort is rather low. If this correct, then fiscal policy left with goal #2
6
Goal #2: GDP stabilization
If supply-side effects are not there or small, then goal of fiscal policy is:
stabilize GDP
when economy overheated, fiscal policy should simply cool it down (by
G and T)
when in recession, fiscal policy should sustain GDP by either T or G
In both cases, fiscal policy meant to affect aggregate demand (by shifting
AD curve)
◦ By how much? It depends on the multiplier
Big issue: does fiscal policy really stabilize GDP?
7
Fiscal Policy..
Fiscal Policy can
◦ boost the level of economic activity if there is a shortage of
demand which is causing a deflationary gap (reflationary policy).
◦ reduce the level of economic activity if too much demand in the
economy is causing an inflationary gap (deflationary policy).
◦ Be used to improve incentives, e.g. through income tax cuts, or
to improve the quality of resources, such as increased
government expenditure on health and education and subsidies
to key areas (supply-side policy).
8
Expansionary Fiscal Policy Contracationary Fiscal Policy
9
Expansionary Fiscal Policy
▪To stimulate the economy when unemployment is greater than the
natural rate
▪An increase in government purchases, decrease in net taxes, or some
combination of the two aimed at increasing aggregate demand
▪A typical Keynesian policy during recession is to use discretionary fiscal
policies to stimulate the economy to a full employment equilibrium
▪It seeks to stimulate production (and consumption)
▪Directly (expenditures ↑)
▪Indirectly (taxes ↓ to encourage household spending or investment
spending)
10
Expansionary Fiscal Policy..
Expansionary $5 billion Recessions
increase in Decrease AD
Fiscal policy is spending
used during a AS
recession to: Full $20 billion
Price level
1. Increase increase in
aggregate demand
government P1
spending
2. Decrease taxes
3. Combination of AD1
both AD2
4. Create a deficit $490 $510
Real GDP (billions) 11
Contractionary Fiscal Policy
A decrease in government purchases, increase in net taxes, or some
combination of the two aimed at reducing aggregate demand
A response to inflation (economy is operating above full employment and
prices are rising)
It is used to slow down the economy when inflation is more than desired
It leads to reduction in interest rates
It seeks to reduce production (and consumption)
◦ Directly (expenditures ↓)
◦ Indirectly (taxes ↑ to discourage household or investment spending)
A politically difficult phenomenon
12
Contractionary Fiscal Policy..
$3 billion initial
Used during demand- decrease in
spending
pull inflation AS
1. Decrease
government spending
Price level
Full $12 billion
2. Increase taxes P2
d c b decrease in
aggregate demand
3. Combination of both a
P1
4. Create a surplus
AD4
AD
AD3 5
$502 $510 $522

Real GDP (billions) 13
Discretionary Vs. Non-discretionary Fiscal Policy
Discretionary Automatic Stabilizers
1. Policymakers change tax policies 1. Implemented without any deliberate action
or spending programs in from policymakers
response to fluctuations in the 2. Found in the tax system and spending
business cycle (at their programs
discretion) 3. Taxes are linked to economic activity
2. Government policies that require a) Progressive income tax rates (individual
ongoing decisions by policy and corporate)
makers b) Payroll taxes
3. Discretionary policy often has c) Sales and excise taxes
limited impacts on the economy. 4. Recessions → automatic “tax cut”
5. Expansion → automatic “tax increase”
14
Automatic or Built-In Stabilizers
Tax System Spending
1. Taxes are linked to economic 1. Government spending responds
activity to the business cycle
a) Progressive income tax rates a) Unemployment insurance
(individual and corporate) benefits
b) Payroll taxes b) Welfare benefits
c) Sales and excise taxes c) School lunch programs
2. Recessions → automatic “tax d) Other income-support
cut” programs
3. Expansion → automatic “tax 2. Recessions → more spending
increase” 3. Expansion → less spending
15
Automatic or Built-in Stabilizers
▪Structural features of
government spending and
taxation smooth out
fluctuations in booms and
busts
▪Example of automatic
stabilizers are
▪(i) Unemployment
payments;
▪(ii) Welfare;
▪(Iii) Other govt. programs
16
Built-In Stability
T
Government expenditures, G,
▪Automatic stabilizers
▪ Taxes vary directly with GDP
and tax revenues, T

▪ Transfers vary inversely with
GDP Surplus
G
▪Reduces severity of business Deficit
fluctuations
▪Tax progressivity
◦ Progressive tax system
◦ Proportional tax system
◦ Regressive tax system
GDP1 GDP2 GDP3
Real domestic output, GDP
17
Discretionary Fiscal Policy
1. Do lag effects influence discretionary fiscal policies?
Answer: Yes, they weaken fiscal policies as a tool of economic
stabilization
2. Is there an effect of politics?
Answer: There is always the danger that politicians can use
discretionary fiscal policies to suit their short term political goals
18
Fiscal Policy Instruments
Taxes Subsidies Government Crowding
Expenditure Out
1. Can be targeted 1. Research and 1. Can be targeted: During periods of
2. Reduces overall development welfare for full employment
consumption 2. Activities corporations or for the government
3. Stabilize economy that provide the poor? can borrow
4. Can have positive 2. Public goods or money that
important impact externalities:
private goods? What otherwise would
on scale 'subsidize
offers highest be spent or
goods, not
bads' marginal benefits? invested
3. Investments in
human made vs.
natural
19
Government Expenditure
▪Government expenditure, also known as government spending, refers to the
resources a government allocates to achieve its strategic objectives and satisfy
the needs of the members of the nation.
▪Governments spend money on health care, education, Social Security benefits,
infrastructure and defence activities.
▪Annual government budgets specify the breakdown of funds for a fiscal year.
▪Total government expenditure includes federal government expenditure, as well
as state and local government expenditure.
▪Economists classify government expenditure into two main types: transfer
payments and purchase of services and goods.
20
Types of Government Expenditure
Government final Capital Expenditures or Fixed Capital Transfer payments
consumption Formation
expenditure
Current Expenditures Capital Expenditures or fixed capital Transfer payments -
or Government final formation (or government investment) - spending that does not
consumption government spending on goods and services involve transactions of
expenditure on goods intended to create future benefits, such goods and services, but
and services for current as infrastructure investment in transport instead represent
use to directly satisfy (roads, rail airports), health (water collection transfers of money, such
individual or collective and distribution, sewage systems, as social security
needs of the members communication (telephone, radio and tv) and payments, pensions and
of the community research spending (defence, space, genetics). unemployment benefit.
21
Public Expenditure
Public Expenditures
Government
Transfers (Tr)
Expenditures (G)
22
Public Expenditure..
Current expenditure Capital Expenditure
1. Current expenditure is expenditure on goods 1. Capital expenditure
and services consumed within the current measures the value of
year.
purchases of fixed assets,
2. Current expenditure includes final
consumption expenditure, property income i.e. those assets that are
paid, subsidies and other current transfers used repeatedly in
(e.g., social security, social assistance, production processes for
pensions and other welfare benefits). more than a year.
3. Goods And Services 2. The value is at full cost
4. Interest Payments
price.
5. Subsidies
6. Transfers 3. Sales of fixed assets are not
deducted.
23
Crowding Out Effect
▪Crowding out effect is a situation when increased interest rates lead to a
reduction in private investment spending such that it dampens the initial
increase of total investment spending.
▪When the government adopts an expansionary fiscal policy stance and
increases its spending to boost the economic activity, it leads to an increase in
interest rates. Increased interest rates affect private investment decisions. A
high magnitude of the crowding out effect may even lead to lesser income in
the economy.
▪With higher interest rates, the cost for funds to be invested increases and
affects their accessibility to debt financing mechanisms. This leads to lesser
investment ultimately and crowds out the impact of the initial rise in the total
investment spending.
24
Crowding Out Effect
The tendency of
expansionary fiscal policy
to cause a decrease in
planned investment or
planned consumption in
the private sector; this
decrease normally results
from the rise of interest
rates.
25
Crowding Out Effect
▪ Private sector spending is
‘crowded-out’ by the
government’s deficit spending.
▪ The crowding out effect refers
to a situation of high
government expenditure
supported by high borrowing
causes decrease in private
expenditure. Or in other
words, when the government
is increasing its expenditure,
private expenditure comes
down.
26
The Crowding-Out Effect, Step by Step
27
Crowding Out and IS-LM curve
▪ Economy is at equilibrium at point E1.
▪ The corresponding income-interest rate combination is r1 – Y1.
▪ An increase in government spending shifts the IS1 curve to IS2,
shifting the equilibrium point to E2.
▪ Consequently, income rises to OY1 from OY, (a full multiplier
effect of government spending).
▪ But the economy is out of equilibrium: goods market is in
equilibrium (since planned expenditure equals aggregate
output), but money market is out of equilibrium. This is because
higher income causes money demand to rise.
▪ This excess demand for money (in the money market) then pulls
up the interest rate, leading to a fall in aggregate demand as it
squeezes out some private investment, tending to reduce the
size of the multiplier effect on income.
▪ Final equilibrium (determined by the IS-LM intersection) now
occurs at point E3 and aggregate output declines to OY3.
28
Crowding Out and AD/AS
Deficit Fiscal Policy AD shifts to AD1 when G increases
The tendency Then shifts back to AD2 as I falls due to
Real ir SLF (Private Savings) Price the increase in interest rates.
of
expansionary Level
SRAS
fiscal policy to
cause a
r1 Pl1
decrease in
planned
investment or Pl2
r
planned PL AD1
consumption (C+I+G1)
in the private
DLF1 (Private
sector; this +
decrease Government) AD2
(C+(I-I1)+G1)
normally DLF
results from (Private
Demand)
the rise of AD
interest rates. (C+I+G)
QLF QLF1 Y Y2 Y1
Quantity of Loanable Funds Real Gross Domestic Product
Barro-Ricardo Effect
▪The Barro-Ricardo Effect is feedback caused by a Crowding Out
effect.
▪Higher interest rates associated with Crowding Out cause individuals
to save more of their incomes.
▪The rise in savings increases the supply of loanable funds, thereby
reducing the real interest rate.
▪The B-R effect has a smaller impact and usually doesn’t fully
negate a crowding out effect.
Illustrating the Crowding-out Effect
Interest rates paid by private borrowers in a nation are a primary determinant of the
levels of savings, investment, and consumption. The market in which private interest
rates is illustrated is called the loanable funds market.
The Loanable Funds Market: A nation's loanable funds market represents

the money in commercial banks that is available to be loaned out to firms
and households to finance private investment and consumption.
• The price of loanable funds is the real interest rate
• The market shows relationships between real returns on savings and
real price of borrowing and the private sector's willingness to save and
invest.
• The supply curve represents household savings
➢ At higher interest rates, households save more
➢ At lower rates, households save less
• The demand curve represents investment

➢ At higher interest rates, firms invest less
➢ At lower interest rates, firms invest more
31
Crowding-out Effect in the Loanable
Funds Market
When a government borrows in order to finance a budget deficit, it must increase
the interest rates on its bonds in order to attract more lenders.
• Higher rates on government debt will lead households to take their savings
out of private banks and lend it to government instead
• This causes the supply of loanable funds to decrease, leading to

higher borrowing costs in the private sector.
➢ Before the expansionary fiscal policy, the level investment was
Qpr.
➢ Higher interest rates on government bonds cause the supply of
loanable funds to decrease to S1.
➢ Less money in banks leads to higher interest rates. The quantity
funds demanded for private investment falls to Qp.
➢ Overall spending increases to Qg, but there is a decrease in
private investment of Qp-Qpr
Private sector spending is ‘crowded-out’ by the government’s deficit
spending. This means AD will not increase by as much as the spending
multiplier would predict. 32
Crowding-out Effect in the AD/AS Model
Let us say a government increases spending by $100
million, without raising taxes. This money must be
borrowed. Assume the multiplier is 4.
The fiscal policy should lead to an increase in AD of $400
million. However…
• If the government’s borrowing reduces the supply of
funds available to the private sector, then higher interest
rates might cause private investment to fall, therefore,
• The total increase in AD will be less than that which was
predicted by the multiplier.
➢ To reach full employment, AD would have to
increase to AD1.
➢ But due to crowding-out, it only increases to AD2.
A much larger stimulus would be needed than the multiplier
predicts, further increasing national debt!
33
Evaluating the Crowding-out Effect
During deep recessions: During mild recessions:
Crowding-out is unlikely to occur; private sector Crowding-out is more likely to occur; resources are close
investment is already deeply depressed. There is very to being fully-employed, and private sector spending is
little spending to crowd out, and government should be relatively high. Government will have to offer higher
able to borrow without raising interest rates by much rates to attract lenders, which could cause private
investment to fall
LRAS SRAS
LRAS PL
PL SRAS
Pfe
Pfe
P2
AD1
P2 AD1
AD2
$100 million
$500 million AD2
Y2 Yfe real GDP
Y2 Yfe real GDP
34
Fiscal Policy Lag Effects
1. Recognition lag
The time required to gather information about the current state of the
economy
2. Decision lag
The time required to take a decision after recognizing the current state of the
economy
3. Action lag
The time required between recognizing an economic problem and putting
policy into effect
4. Effect Time lag
The time it takes for a fiscal policy to affect the economy
35
Three Pillars of Keynesian Economics
1. Liquidity Trap:
A lack of borrowing keeps money bottled up in savings institutions. A
Keynesian solution to a liquidity trap is that Government borrows the
money that consumers and business do not borrow.
2. Balanced Budget Multiplier:
When the government taxes and spends the money there is a multiple
effect because of no savings
3. Paradox of thrift:
The more people save, the less will be demand, which leads to slow
growth
36
How fiscal policy affects business?
▪Businesses directly experience the effects of fiscal policy whether it's in the form
of spending or taxation.
▪Businesses can foresee investment opportunities from government spending as
well as private investment. This commonly happens during an expansionary policy,
when more money is flowing into the economy from the government and from
other sources since taxation is also low.
▪When a balance between price and demand are met, then businesses can expect
to thrive and grow.
▪A contractionary financial policy may kick in to prevent inflation when that
balance is broken and demand and prices fall. Businesses typically reign in their
growth due to rising taxes and take measures to stay in the black with less money
flowing through the economy.
37
How effective are fiscal policies?
▪Automatic or built-in stabilizers are more effective than are
discretionary fiscal policies
▪The stronger and more effective the automatic stabilizers
are, the less need there is for discretionary fiscal policies
38
Does fiscal policy really stabilize GDP?
Three possible reasons for why this may not be
the case
1. Political delays
2. Ricardian equivalence
3. Crowding out
39
Reasons why fiscal policy may not stabilize GDP?
Political delays Ricardian equivalence Crowding Out
‘Right’ fiscal policy Robert Barro Suppose G to counteract recession; expect
stance hardly If T temporary, effects on AD very large effect on AD (shift of AD)?
No, if other AD items ‘crowded out’
delivered when small How is G financed? Suppose G financed by
needed. Approval Why? DEF
takes time If tax cut is “temporary”, then people  DEF  price of T-bonds and interest rates
 I (private investment)
When tax cuts to would save additional income overall effect on AD dampened
sustain GDP obtain from tax cut, rather than By how much, it depends on how responsive
Parliament consume it investment and savings are to interest rates
With today’s high K mobility, only if large
approval, it may be If G has not been cut in parallel, I economy (e.g USA, Euroland or OECD) runs
too late expect taxes up tomorrow & a large DEF will it have an impact on world
save to meet future tax interest rates; unlikely to work for small
If approved and economies in isolation
obligations
implemented late, if G financed by T: T  C, effect on AD
risk of GDP de- Hence AD stays where it is dampened either
stabilization If Barro is right, changing tax rates If crowding out important, stabilizing role of
does not stabilize GDP fiscal policy may not be there
40
Ricardian Equivalence
▪Ricardian equivalence suggests that when a government tries to
stimulate an economy by increasing debt-financed government
spending, demand remains unchanged.
▪Aggregate Demand (AD) remains unchanged due to the fact that the
public saves its excess money to pay for expected future tax increases
that will be used to pay off the debt.
▪Ricardian Equivalence holds if taxation and government borrowing
both have the same effect on spending in the private sector.
▪Ricardian equivalence theory was developed by David Ricardo in the
19th century but was revised by Harvard professor Robert Barro into a
more elaborate version of the same concept.
41
Two arguments for Fiscal Policy
Efficiency Equity
Efficiency refers to the Equity refers to the
collective well being of distribution of well being
an economy. across individual in an
economy.
Can we use fiscal policy to
Can we use fiscal policy to
redistribute income in a “fair”
increase aggregate income?
way?
42
Fiscal Policy - Challenges
1. Political factors
2. Time lags
a) Time required to create and pass legislation
b) Time required to implement legislation
3. Supply side impacts
4. Forecasting difficulties
5. Monetary policies may reinforce or offset fiscal policies
43
Taxes
▪A tax may be defined as a "pecuniary burden laid upon
individuals or property owners to support the
government, a payment exacted by legislative
authority.”
▪A tax "is not a voluntary payment or donation, but an
enforced contribution, exacted pursuant to legislative
authority".
▪Taxes: Direct and Indirect
Direct Taxes are Income Tax; Corporation Tax; Property
Tax; Inheritance (Estate) Tax; Gift Tax.
Indirect Taxes are Goods and Services Tax; Customs Duty
44
Tax structure- Direct and Indirect tax
Direct Taxes Indirect Taxes
1. A Direct tax is a kind of charge, 1. An indirect tax is a tax collected by an
which is imposed directly on the intermediary (such as a retail store) from the
taxpayer and paid directly to the person who bears the ultimate economic
government by the persons (juristic burden of the tax (such as the customer).
or natural) on whom it is imposed. 2. An indirect tax is one that can be shifted by the
2. A direct tax is one that cannot be taxpayer to someone else.
shifted by the taxpayer to someone 3. An indirect tax may increase the price of a good
else. so that consumers are actually paying the tax
3. The some important direct taxes by paying more for the products.
imposed in India are as under: 4. The some important indirect taxes imposed in
Income Tax; Corporation Tax; India are as under: Goods and Services Tax;
Property Tax; Inheritance (Estate) Customs Duty
Tax; Gift Tax.
45
Nature of Taxes
Regressive
• % of income paid in taxes ↓ as income ↑
Progressive
• % of income paid in taxes ↑ as income ↑
Proportional
• % of income paid in taxes is fixed as income
changes
46
Benefits of GST
1 Reduction in Cascading of Taxes
Decrease in
2 Overall Reduction in Prices Inflation
3 Common National Market

Ease of Doing
4 Benefits to Small Taxpayers Business
5 Self-Regulating Tax System

Decrease in “Black”
Non-Intrusive Electronic Tax System Transactions
6
47
Benefits of GST ..
7 Simplified Tax Regime
More informed
8 Reduction in Multiplicity of Taxes consumer
9 Consumption Based Tax

Poorer States
10 Abolition of CST to Gain
11 Exports to be Zero Rated

Make in India
12 Protection of Domestic Ind. - IGST
48
Central Taxes
Multiple State Taxes Single Tax-GST
Tax Multiple State Tax
Administrations Single Tax
Administrations Administration
CEx/ST Act & Rules Multiple Acts & Rules
Uniform law
Procedures Multiple procedures
Computerized
uniform procedures
Pre-GST Indirect tax structure in India
GST
GST
CGST
CGST SGST/UTGST
SGST/UTGST IGST
IGST
GST Structure in India

Goods and Services Tax
▪“Goods and services tax” means any tax on supply of goods, or services or both
except taxes on the supply of the alcoholic liquor for human consumption. (w.e.f 1
July, 2017)
▪GST includes Central Excise duty, Duties of Excise (medicinal and toilet preparations),
Additional Duties of Excise (goods of special importance), Additional Duties of Excise
(textile and textile products), Additional Duties of Customs, Special Additional Duties
of Customs, Service Tax, and Central surcharges and cesses.
▪The State taxes subsumed under GST include State VAT, Entry Tax, Central Sales Tax,
Entertainment and Amusement Tax, Luxury Tax, Purchase Tax, Taxes on
advertisements.
▪GST have been categorised under four tax slabs, viz. 5%, 12%, 18%, and 28%.
50
Goods and Services Tax
Exempted GST 5% GST Rate Slab 12% GST Rate Slab 18% GST Rate Slab 28% GST Rate Slab
Rate Slab (No Tax)
7% of goods and 14% of goods and 17% of goods and 43% of goods and 19% of goods and
services fall under services fall under services fall under services fall under services fall under
this category this category this category. this category. this category.
Fresh fruits and Packaged food Edibles like frozen Pasta, biscuits, The rest of the
vegetables, milk, items, cream, meat products, cornflakes, pastries edibles like
etc. skimmed milk butter, cheese, and cakes, chewing gum, bidi,
powder, branded ghee, dry fruits in preserved molasses, waffles
paneer, frozen packaged form, vegetables, jams, and wafers coated
vegetables, coffee, etc. soups, ice cream, with chocolate,
tea, spices, pizza mayonnaise, mixed pan masala,
bread, etc. condiments and aerated water, etc.
seasonings,
mineral water, etc.
51
Benefits of GST
1 Reduction in Cascading of Taxes
Decrease in
2 Overall Reduction in Prices Inflation
3 Common National Market

Ease of Doing
4 Benefits to Small Taxpayers Business
5 Self-Regulating Tax System

Decrease in “Black”
Non-Intrusive Electronic Tax System Transactions
6
52
Benefits of GST ..
7 Simplified Tax Regime
More informed
8 Reduction in Multiplicity of Taxes consumer
9 Consumption Based Tax

Poorer States
10 Abolition of CST to Gain
11 Exports to be Zero Rated

Make in India
12 Protection of Domestic Ind. - IGST
53
What is Laffer Curve?
▪The Laffer Curve describes the relationship between the tax rate and the tax
revenue it generates
▪The Laffer Curve implies there is an “optimal” tax rate, a tax rate that
maximizes tax revenue.
▪The Laffer curve is the graphical representation of the relationship
between tax rates and absolute revenue these rates generate for the
government.
▪The principle thought behind the Laffer curve is that a zero tax rate would
produce zero revenue and a 100% tax rate would also generate zero revenue,
as there would be no incentive to work. This means there must be an optimal
tax rate that will yield maximum revenue for the government.
▪The Laffer curve gets its name from economist Arthur Laffer
54
Laffer curve
A curve that shows that
starting from zero an
increase in taxes will
raise revenue but beyond
a point an increase will
lower revenues
55
Laffer Curve..
What is the case in India?
Although the current rate of taxes in India is considered moderate, it is felt that
lowering the tax rate will increase compliance further, particularly in the case of
individuals.
What is the case around the world?
A recent paper of the European Central Bank says that the US could increase tax
revenues by as much as 30% by raising labour taxes or tax on income and 6% by
raising capital income taxes or tax on business.
For a select 14 countries of the EU, the benefit from rate hike can be only 8% and 1%,
respectively.
The study notes that Denmark and Sweden are on the wrong side of the Laffer curve
for capital income taxation.
56
Measuring Fiscal Policy’s Effects
▪Effects are not limited to the initial dollar value of the change in
policy
▪The eventual effects may be larger or smaller, depending on:
1. Multiplier effect
2. Crowding-out effect
Fiscal operations
Fiscal operations are actions taken by the government to
implement budgetary policies, such as revenue and expenditure
measures, as well as issuance of public debt instruments and
public debt management.
57
Budget Lingo
Balanced budget
• Revenues = Expenditures
Budget deficit
• Revenues < Expenditures
Budget surplus
• Revenues > Expenditures
Government debt
• Sum of all deficits – Sum of all surpluses
58
Budget Glossary
Revenue Receipts:
The earnings made by the government which neither create liabilities or reduce assets
of the government. For example, receipts from tax collections, interest on investments,
dividend earnings and earnings from services provided.
Capital Receipts:
The earnings made by the government which creates liabilities (borrowing from the
public in form of PPF and small saving deposits, National Pension Scheme etc. ) or
reduce assets (divesting stake in a particular company, called disinvestment or
recovering loans made to state governments.)
Non-debt Capital Receipts
These are capital receipts which do not create debt for the government such as
recovery of loans made and selling a stake in a public company.
59
Budget Glossary..
Revenue expenditure:
It is the expenditure made by the government on a recurring basis such as
administrative expenses, interest payments on loan taken by the
government, pensions, subsidies etc.
Capital expenditure:
It is a productive, asset-creating (or liability reducing) long-period, non-
recurring expenditure of the government. For example; expenditure on
creating the infrastructure (roads, electricity dams etc.), loans made to
state governments and repayment of loans by the central government
(reducing liability).
60
Budget Glossary…
Gross Fiscal Deficit (GFD):
GFD of the government is the difference between the total expenditure incurred and the
total non-debt capital receipts (total receipts minus the earnings from borrowing) of the
government. GFD indicates the total borrowing requirements (incl. the need for interest
payments) of the government.
Revenue Deficit (RD):
RD is the difference between the revenue receipts and the revenue expenditure of the
central government. RD indicates the excess amount of expenditure by the government to
fund current consumption needs rather than for productive asset-creation.
Gross Primary Deficit (GPD):
GPD is the difference between the fiscal deficit of the current year and the interest
payments on the previous borrowings made by the government. GPD indicates how much
of the government borrowing is going to meet expenses other than interest payments.
61
Gross Budgetary Support
▪The government’s support to the Central plan is called Gross Budgetary Support.
▪The Central plan forms the annual expenditure of the government and is
incurred keeping the objectives of 5-year plans in mind.
▪Budgetary Support is earmarked for meeting the planned outlays of the Central
government during the financial year.
▪Plan outlays are incurred for development of heterogeneous sectors like
agriculture and allied activities, rural areas, irrigation and flood control, energy,
industry and minerals, transport, communications, science, technology and
environment, social services like education, mid day meal scheme, Sarva Shiksha
Abhiyan, health, housing, police, justice administration etc.
62
Fiscal Deficit
▪Fiscal Deficit is the difference between total revenue and total expenditure of the government.
▪Fiscal Deficit is an indication of the total borrowings needed by the government.
▪While calculating the total revenue, borrowings are not included.
▪The gross fiscal deficit (GFD) is the excess of total expenditure including loans net of recovery over
revenue receipts (including external grants) and non-debt capital receipts. The net fiscal deficit is the
gross fiscal deficit less net lending of the Central government.
▪Generally fiscal deficit takes place either due to revenue deficit or a major hike in capital expenditure.
Capital expenditure is incurred to create long-term assets such as factories, buildings and other
development.
▪A deficit is usually financed through borrowing from either the central bank of the country or raising
money from capital markets by issuing different instruments like treasury bills and bonds.
▪Fiscal consolidation is a policy aimed at reducing government deficits and debt accumulation.
63
Fiscal Deficit - classification
Gross Fiscal Deficit (GFD) Net Fiscal Deficit
The gross fiscal deficit (GFD) is The net fiscal deficit is the gross
the excess of total expenditure fiscal deficit less net lending of
including loans net of recovery the Central government.
over revenue receipts (including
external grants) and non-debt
capital receipts.
64
Deficit Types
Deficit Types
Revenue deficit = Fiscal deficit =

Primary deficit =
Total revenue Total expenditure – Total Fiscal deficit-Interest
expenditure – Total receipts excluding payments
revenue receipts borrowings
65
India - Budget at a Glance
India Budget at a Glance (In INR crore)
2016-2017 2017-2018 2017-2018 2018-2019
Actuals Budget Estimates Revised Estimates Budget Estimates
1Revenue Receipts 1374203 1515771 1505428 1725738
2. Tax Revenue 1101372 1227014 1269454 1480649
(Net to Centre)
3. Non-Tax Revenue 272831 288757 235974 245089
4Capital Receipts 600991 630964 712322 716475
5. Recovery of Loans 17630 11933 17473 12199
6. Other Receipts 47743 72500 100000 80000
7. Borrowings and Other Liabilities 535618 546531 594849 624276
8Total Receipts (1+4) 1975194 2146735 2217750 2442213
9Total Expenditure (10+13) 1975194 2146735 2217750 2442213
10On Revenue Account 1690584 1836934 1944305 2141772
of which
11Interest Payments 480714 523078 530843 575795
12Grants in Aid for creation
of capital assets 165733 195350 189245 195345
13On Capital Account 284610 309801 273445 300441
66
India Budget –Deficits at a Glance
(In INR crore)
2016-2017 2017-2018 2017-2018 2018-2019
Actuals Budget Estimates Revised Estimates Budget Estimates
Revenue Deficit 316381 321163 438877 416034

-2.1 -1.9 -2.6 -2.2
Effective Revenue Deficit 150648 125813 249632 220689
-1 -0.7 -1.5 -1.2
Fiscal Deficit 535618 546531 594849 624276
-3.5 -3.2 -3.5 -3.3
Primary Deficit 54904 23453 64006 48481
-0.4 -0.1 -0.4 -0.3
67
India – Deficit Trends
▪ Gross Primary Deficit is Gross Fiscal Deficit
less interest payments.
▪ Net Primary Deficit is Net Fiscal Deficit minus
net interest payments.
▪ Net interest payment is interest paid minus
interest receipt.
▪ While fiscal deficit is the difference between
total revenue and expenditure, primary deficit
can be arrived by deducting interest payment
from fiscal deficit.
▪ Interest payment is the payment that a
government makes on its borrowings to the
creditors
68
Deficit
▪Deficit occurs when government spending (purchases &
transfers) exceeds tax receipts
▪Primary deficit is one of the parts of fiscal deficit.
▪While Fiscal Deficit is the difference between total
revenue and expenditure, Primary Deficit can be arrived
by deducting interest payment from fiscal deficit.
▪Interest payment is the payment that a government
makes on its borrowings to the creditors
69
Budget Deficit and Debt
• Budget deficit (DEF) = G + Ig + Tr + iD-1– T ▪G = Govt purchases of goods and
• DEF goes up in recessions and down in booms services (for education, justices,
defense)
▪ Why? In recession: Tr and T (why?) ▪Ig = public investment (for roads,
▪ Hence: in recession, DEF. The opposite during highways)
▪Tr = transfers (pensions, assistance
booms
to the poor). Tr  G or Ig: doesn’t
▪ Structural DEF computed as if GDP were at its have to do with provision of goods
potential and services
▪iD-1 = interest payments on
• Balanced budget: DEF=0, G + + Ig Tr + iD-1 = T
outstanding debt (another type of
• Primary deficit = (G + Ig + Tr – T) transfers)
▪T = indirect taxes (e.g. VAT) + direct
• Deficit is not debt: debt = sum of current and past
taxes (personal & corporate taxes) +
deficits social security contributions
70
India
Deficit Financing
71
Deficit
▪Deficit occurs when government spending (purchases &
transfers) exceeds tax receipts
▪Primary deficit is one of the parts of fiscal deficit.
▪While Fiscal Deficit is the difference between total
revenue and expenditure, Primary Deficit can be arrived
by deducting interest payment from fiscal deficit.
▪Interest payment is the payment that a government
makes on its borrowings to the creditors
72
Fiscal Consolidation
▪Fiscal consolidation is a process where government’s fiscal health is getting
improved and is indicated by reduced fiscal deficit.
▪Improved tax revenue realization and better aligned expenditure are the
components of fiscal consolidation as the fiscal deficit reaches at a
manageable level.
▪Fiscal consolidation is a reduction in the underlying fiscal deficit. It is not
aimed at eliminating fiscal debt
▪In India, fiscal consolidation or the fiscal roadmap for the centre is
expressed in terms of the budgetary targets (fiscal deficit and revenue
deficit) to be realized in successive budgets.
▪The Fiscal Responsibility and Budget Management (FRBM) Act gives the
targets for fiscal consolidation in India.
73
Fiscal Consolidation
▪Fiscal consolidation is a process where government’s fiscal health is getting
improved and is indicated by reduced fiscal deficit.
▪Improved tax revenue realization and better aligned expenditure are the
components of fiscal consolidation as the fiscal deficit reaches at a
manageable level.
▪Fiscal consolidation is a reduction in the underlying fiscal deficit. It is not
aimed at eliminating fiscal debt
▪In India, fiscal consolidation or the fiscal roadmap for the centre is
expressed in terms of the budgetary targets (fiscal deficit and revenue
deficit) to be realized in successive budgets. The Fiscal Responsibility and
Budget Management (FRBM) Act gives the targets for fiscal consolidation in
India.
74
What is FRBM Act?
▪The Fiscal Responsibility and Budget Management (FRBM) Act was enacted in
2003.
▪FRBM sets targets for the government to reduce fiscal deficits.
▪The targets were put off several times.
▪In May 2016, the government set up a committee under NK Singh to review the
FRBM Act.
▪The committee recommended that the government should target a fiscal deficit
of 3 per cent of the GDP in years up to March 31, 2020 cut it to 2.8 per cent in
2020-21 and to 2.5 percent.
75
Public Debt
▪Public debt are the external obligations of the government and
public sector agencies.
▪Public external debt is the external debt obligations of the public
sector.
▪Government debt (also known as public interest, public debt,
national debt and sovereign debt) is the debt owed by a
government.
▪By contrast, the annual "government deficit" refers to the difference
between government receipts and spending in a single year.
76
Role of Fiscal Policy during inflation
During Inflation the following is the Fiscal policy approach:
◦ Inflation can be reduced by policies that slow down the growth of Aggregate
Demand (AD) and/or boost the rate of growth of Aggregate Supply (AS).
◦ To control inflation there is a need to control aggregate demand. If the
government believes that AD is too high, it may choose to ‘tighten fiscal
policy’ by reducing its own spending on public and merit goods or welfare
payments
◦ It can choose to raise direct taxes, leading to a reduction in real disposable
income
◦ The consequence may be that demand and output are lower which has a
negative effect on jobs and real economic growth in the short-term.
77
Role of Fiscal Policy during deflation
During Deflation, the following Fiscal policy is adopted:
◦This involves increasing AD.
◦Therefore the government will increase spending (G)
and cut taxes (T).
◦Lower taxes will increase consumers spending because
they have more disposable income (C)
◦This will tend to worsen the government budget deficit,
and the government will need to increase borrowing.
78
Green Taxation
What is green taxation?
▪Environmental or green taxes include taxes on energy, transport,
pollution, and resources. Energy taxes are taxes on energy products
and electricity used for transport, such as petrol and diesel, and for
other purposes, such as fuel oils, natural gas, coal and electricity
used in heating.
▪Green taxation can also help promote sustainable growth, support
intergenerational fairness and maintain tax revenue levels.
79
Green Subsidies
What are Green Subsidies?
▪Green subsidies have been put in place in order to reduce the
carbon footprint. They are designed to encourage energy
companies to move from carbon-based energy sources to
renewable sources.
80
Key words
Fiscal Policy
Discretionary Fiscal Policy Primary Deficit
Non-discretionary Fiscal Policy Revenue Deficit
Direct Tax Laffer Curve
Indirect Tax Crowding out effect
GST Public Debt
Budget
Budget Deficit
81
Thank you.
That’s all for
this session!

IS-LM
Framework
Professor
Coverage
1. Product and Money Market Equilibrium
2. Hicks-Hansen Model: IS-LM analysis.
3. The slope of the IS curve
4. Shift in the IS curve
5. Shift of the LM curve
6. Monetary Policy and its impacts on the LM curve
7. Fiscal Policy and its impact on the IS curve
2
General Equilibrium of Product and
Money Market
▪IS - LM Framework – General Equilibrium of Product and Money
Market
▪IS-LM Framework is a macroeconomic tool that demonstrates the
relationship between interest rates and real output in the goods and
services market and the money market.
▪The intersection of the IS and LM curves is the "General Equilibrium"
where there is simultaneous equilibrium in both markets.
▪IS stands for Investment Saving & LM stands for Liquidity preference
Money supply .
3
IS-LM Model
▪The IS-LM (Investment Saving – Liquidity Preference Money Supply)
model is a macroeconomic model that graphically represents two
intersecting curves.
▪The investment/saving (IS) curve is a variation of the income-
expenditure model incorporating market interest rates (demand).
▪The liquidity preference/money supply equilibrium (LM) curve
represents the amount of money available for investing (supply).
▪Hicks (1949) is credited with the invention of the IS-LM.
▪Hicks labelled SI-LL which later Alvin Hansen relabelled as showing IS
and LM curves in 1949
4
IS-LM Model
The IS-LM model is a way
to explain and distill the
economic ideas put forth
by John Maynard Keynes
in the 1930s. The model
was developed by the
economist John Hicks in
1937, after Keynes
published his magnum
opus The General Theory
of Employment, Interest
and Money (1936).
5
What is IS-LM?
Investment: In the macroeconomics context, an investment is defined as a
quantity of goods purchased in a period of time that is not consumed or used in
that time. Investment increases as interest rates decrease.
Savings: In the macroeconomics context, it is sometimes known as deferred
consumption, i.e. income that is not spent. As the interest rate falls, savings also
falls, as most households take advantage of lower interest rate to make more
purchases.
Liquidity: It refers to the demand for and amount of real money, in all of its
forms, in an economy.
Money: It is any verifiable record or item that can be used as a medium of
exchange, a store of value, a measure of value (unit of account), and a standard
of deferred payment
6
IS-LM Model (Hicks-Hansen model)
▪IS-LM model is the core of short-run macroeconomics
▪The determination of output and interest rates in the short-run
▪The IS-LM model translates the General Theory of Keynes into neoclassical terms (often
called the neoclassic synthesis )
▪Developed by Keynes (1936)
▪Made famous by Hicks and Hansen
▪It was proposed by John Hicks in 1937 in a paper called “Mr Keynes and the "Classics":
A Suggested Interpretation” and enhanced by Alvin Hansen (hence it is also called the
Hicks-Hansen model).
▪Tool for macroeconomists during 1950s to 1970s
▪With rational expectations revolution, approach seemed to fall out of favour
▪Recent literature (McCallum, Rotemberg, Woodford, etc) has resurrected it
7
IS-LM Model
The model examines the combined equilibrium of
two markets :
◦The goods market, which is at equilibrium when
investments equal savings, hence IS.
◦The money market, which is at equilibrium when the
demand for liquidity equals money supply, hence LM.
◦Examining the joint equilibrium in these two markets
allows us to determine two variables : output Y and the
interest rate i.
8
IS-LM Model
IS-LM model is based on two fundamental assumptions:
1. All prices (including wages) are fixed.
2. There exists excess production capacity in the economy
This is a complete change in perspective compared to classical economics:
◦ The level of demand determines the level of output and employment.
◦ There can be an equilibrium level of involuntary unemployment.
Why can there be insufficient demand?
◦ Criticism of Say’s law: Uncertainty can lead to precautionary saving rather
than consumption.
◦ Monetary criticism: the preference for liquidity can lead to under-
investment as savings are kept in the form of liquidity.
9
IS-LM Model
The IS-LM model has become the “standard model” in macroeconomics.
Its essential contribution (linked to that of Keynes) is this potential equilibrium
unemployment:
◦ Such a situation is impossible in earlier neoclassic models, as the price of labour (like all
prices) is assumed to adjust naturally until supply and demand for labour are balanced.
This is why IS-LM (1937!!) remains central to modern macroeconomics, and has
been extended to explain more markets/ variables:
◦ The AS-AD model adds inflation into the problem
◦ The Mundell-Fleming model deals with international trade
10
IS Curve and the Goods Market
The IS curve exhibits the combinations of interest rates Slopes downward
and levels of output such that planned spending equals r because
income
◦ It is derived in two steps: r→ I→ Y
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 IS
1. Interest rates are the cost of borrowing money
2. Increased interest rates raise the price to firms Y
of borrowing for capital equipment → reduce
the quantity of investment demand 11
The IS Curve: Interest Rate and Aggregate Demand
Need to modify the AD function of the last chapter to reflect the new
planned investment spending schedule
AD = C + I + G + NX
= C + cT R + c(1 − t )Y  + ( I − bi) + G + NX
= A + c(1 − t )Y − bi
▪An increase in i reduces AD for a given level of income

▪At any given level of i, can determine the equilibrium level of income
and output
▪A change in i will change the equilibrium
12
11-12
The IS curve
▪The IS curve shows all the combinations of interest rates i and outputs Y for which the goods market is in
equilibrium
The Investment function The Savings function:

Is the sum of private investment (endogenous) Is obtained from the aggregate demand equation,
and public investment (exogenous) subtracting investment and consumption:
I g = I ( i )+ ( G − T ) S=Y-C-T
−
Here, the interest rate is the marginal S= -C0 +(1-c)(Y-T)
profitability of investment
13
The Investment-Saving (IS) Curve
▪IS curve: equilibrium in the goods market.
– As interest rates rise, output falls.
▪ Demand:
▪ Z = C(Y-T) + I(Y,i) + G
▪ Equilibrium:
▪ Y = C(Y-T) + I(Y,i) + G
▪ Movements along the IS curve: As interest rates rise, output falls.
▪ Shifts in the IS curve: As government spending increases, output increases for
▪any given interest rate.
14
Keynesian Cross
A simple closed economy model in which income is
determined by expenditure. (due to J.M. Keynes). It
identifies equilibrium income.
Notation:
I = planned investment
E = C + I + G = planned expenditure
Y = real GDP = actual expenditure
Difference between actual & planned expenditure = unplanned
inventory investment
The two lines cross at A, meaning that here actual expenditure
equals planned expenditure/spending, and that planned
spending is perfectly compatible with income.
Keynesian cross:
◦ basic model of income determination
◦ takes fiscal policy & investment as exogenous
◦ fiscal policy has a multiplier effect on income.
15
Deriving the IS Curve Keynesian Cross
from Keynesian Cross E
Actual expenditure
E =Y E =C +I (r1 )+G
A rise in
E =C +I (r2 )+G
Interest rate↑ leads to
Expenditure
interest rate
Planned expenditure
Investment↓ causes fall in
I
investment
Expenditure↓ expenditure
Output↓
Investment Function Y2 Y1 Y (output)
r r
IS curve
r2 r2
Interest rate
Interest rate↓ leads to

r1 r1
Investment↑
Expenditure↑ I IS
Investment I Y2 Y1 Y (output)
Output ↑
Fiscal Policy and its impact on IS curve
An increase in taxes T↑
shifts the IS curve to the left.
• Equilibrium in the goods market
implies that an increase in the
interest rate leads to a decrease
in output.
• Changes in factors that
decrease the demand for
goods, given the interest rate
shift the IS curve to the left.
17
Autonomous
spending and IS curve
• Figure shows two different IS curves
→ differ by levels of autonomous
spending
– Initial AD with and i1 →
corresponding point E1 on IS curve in
Figure (b)
– If autonomous spending increases to ,
the equilibrium level of income
increases at i1 → point E2 in panel (b),
shifting out IS
• The change in income as a result
from a change in autonomous
spending is
18
The Shift in the IS Curve
IS Curve: At lower interest rates, equilibrium IS Curves: An increase in government
output in the goods market is higher. spending shifts out the IS curve.
19
The IS Curve: Why is it downward sloping?
r
Slopes downward because
r→ I→ Y
Recall that:
I+T=S+G
or
I(r) + T0 = S(Y) + G0
Differentiate implicitly with respect to Y and r:
IS ds
dr dY (+)
Y = = 0
dY dI ( −)
dr
20
The Slope of the IS Curve
The steepness of the IS curve depends on two things:
◦(i) Interest elasticity of investment
◦(ii) MPS, i.e., the slope of saving curve.
The slope of the curve is of significant interest to us because
it is a factor determining the relative effectiveness of
stabilisation policies, viz., monetary and fiscal policies
21
The LM Curve
▪The LM curve shows all the
combinations of interest rates i
and outputs Y for which the
money market is in equilibrium
▪Here, the interest rate i has a
monetary interpretation:
▪It is the opportunity cost of
money, in other words the
payment made for renouncing
liquidity (preference for liquidity)
22
The LM Curve and the Money Market
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
◦ Theory of real money balances, rather than nominal
2.Equate money demand with money supply, and find combinations of
income and interest rates that maintain equilibrium in the money market
◦ (i, Y) pairs meeting this criteria are points on a given LM curve
23
The Liquidity preference – Money supply
(LM) Curve
•LM curve: equilibrium in the money market.
– As output rises, interest rates rise.
• Demand for real balances: Md /P = Y L(i)
• Equilibrium in money market: Md=M
• LM Curve: M/P = Y L(i)
• Movements along the LM Curve: An increase in Y increases money demand, which
causes an increase in interest rates to maintain money market equilibrium.
• Shifts in the LM curve: An increase in money supply lowers interest rates at any given
level of output.
24
The LM Curve
Liquidity preference:
With a level of output Y, the level of interest i adjusts so that the demand for
money (given by the liquidity function L) equals the exogenous supply:
M
P
= L Y,i
+ −
( )
M = Money supple (exogenous)
P = Level of prices (exogenous by assumption)
25
The LM Curve
There are two motives for demanding real money balances:
1. The transaction and precautionary motive L1(Y) : The money demanded in order to be able to transact
in the future (function of the level of output)
2. The speculation motive L2(i) : The money demanded for purposes of speculation (opportunity cost of
the interest rate). When interest is high, people don’t want to hold money, whereas when the rates are
low, money demanded increases.
26
Deriving the LM
(a) The market for
Curve real money balances
(b) The LM curve
Why is the LM curve upward r r
Interest rate
Interest rate
sloping? LM
• An increase in income
raises money demand.
• Since the supply of real r2 r2
balances is fixed, there is
now excess demand in the L (r , Y2 )
money market at the initial r1 r1
interest rate. L (r , Y1 )
• The interest rate must rise
to restore equilibrium in
the money market. M1 M/P Y1 Y2 Y
Output
P Real money balance
27
Monetary Policy and its impacts on LM curve
▪Monetary policy impact on the LM curve can be
understood in two dimensions:
1) Changes in the money supply
2) Autonomous changes in money demand
28
The Shift in the LM Curve
The Effects of a Monetary
Expansion
An increase in money leads the LM curve
to shift down.
▪ Equilibrium in financial markets
implies that, for a given real money
supply, an increase in the level of
income, which increases the demand
for money, leads to an increase in the
interest rate.
▪ An increase in the money supply shifts
the LM curve down; a decrease in the
money supply shifts the LM curve up. 29
The Shift in the LM Curve
LM Curve: At higher levels of output, equilibrium An increase in money supply shifts the LM Curve. At
in the money market implies higher interest rates. the current level of output, the interest rate required
to maintain equilibrium in the money market is lower.
30
The Shift in LM Curve: Increase in Money Supply
31
The Shift in LM Curve: Increase in Money Demand
32
The Supply of Money, Money Market
Equilibrium, and the LM Curve
Figure shows the
combinations of i and Y
such that demand for real
money balances exactly
matches available supply.
Assumption:
Real money supply is
M/P, where M and P are
assumed fixed
Point E1 is the equilibrium
point in the money
market
As Income increases to
Y2, interest rate moves to
i2. Then, the new
equilibrium moves to E2
33
What shifts the LM curve?
Money: Increasing Money Supply increases M/P causing the LM curve
to the right.
Prices: Increasing Prices causes real Money Balances to fall shifting LM

curve to the left.
Expected Inflation π e: Increasing expected inflation causes returns

on bonds (assets other than money) to increase making it less
attractive to hold cash. Causes LM curve to shift right!
34
The LM Curve: Hicks interpretation
r LM Curve (L=M): all
LM those combinations of
real interest rates and
income which bring the
money supply equal to
money demand.
35
The LM Curve slopes upwards?
If Y increases, transactions and
precautionary demand increase.
r LM
There will be excess demand in the r
money markets Ms
Interest rates will be driven upward
So Y→ r, and the LM Curve slopes Md(Y2)
upward.
Liquidity Preference is: L = L(Y,r)
r1 Md(Y1)
Money Supply is: Ms = M0 = M
r0 Md(Y0)
Ms = Md implies M = L(Y,r) → LM Curve
− L
dr
= Y = − ( + )  0
dY L ( −) M Y0 Y1 Y2 Y
r
36 36
The Slope of the LM Curve
The steeper the LM curve:
◦ The greater the responsiveness of the demand for money to income, as
measured by k
◦ The lower the responsiveness of the demand for money to the interest rate, h
→These points can be confirmed by examining equation:
1 M
i =  kY − 
h P 
→A given change in income has a larger effect on i, the larger is k and the smaller
is h
37
Equilibrium in goods and money market
▪ The IS-LM model shows that monetary
policy influences income by changing
the interest rate.
▪ The IS-LM model shows that an
increase in the money supply lowers
the interest rate, which stimulates
investment and thereby expands the
demand for goods and services.
▪ Assumptions:
▪ Price level is constant
▪ Firms willing to supply whatever
amount of output is demanded
at that price level
38
Changes in the Equilibrium Levels of
Income and the Interest Rate
The equilibrium levels of income
and the interest rate change when
either the IS or the LM curve shifts
Figure shows effects of an increase
in autonomous spending
▪ Shifts IS curve out by G ∆I if
autonomous investment is the source
of increased spending
▪ The resulting change in Y is smaller
than the change in autonomous
spending due to slope of LM curve
39
IS-LM Framework: Limitations
McCallum and Nelson (1997) observe 6 limitations:
◦ 1. IS-LM analysis presumes a fixed, rigid price level
◦ 2. No distinction between real and nominal rates
◦ 3. Only 2 assets; money and bonds
◦ 4. Only short-run, no steady states
◦ 5. Capital stock fixed
◦ 6. Not derived using microfoundations => Lucas Critique
Rational Expectations revolution: Move away from IS-LM
(although equivalent expressions were still used!)
40
IS-LM Framework: Drawbacks
▪Does not take into account a huge variety of factors the come to play in
the modern economy, such as international trade, demand, and capital
flows.
▪Takes a simplistic approach to fiscal policy, the money market, and money
supply. Central banks today in most advanced economies prefer to control
interest rates on the open market—for example, through sales of
securities and bonds. This model cannot account for that should not be
used as the sole tool in determining monetary policy.
▪Does not reveal anything about inflation or international trade, and does
not provide insight or recommendations toward formulating tax rates and
government spending.
41
The IS-LM
◼The real and monetary sectors of the
r economy are resolved together.
LM
◼Money matters to real sector
outcomes.
◼There is no dichotomy (contrast).
r*
◼Assumptions:
◼Price level is constant
IS ◼Firms willing to supply whatever
Y* amount of output is demanded at that
Y
price level
42
42
The IS-LM model
▪LM is a stock equilibrium (beginning of period).
▪IS is a flow equilibrium (end of period).
▪The model is an equilibrium of flows constrained by stocks. It is a
cash-flow equilibrium.
▪The time frame is long enough for full adjustment of real income and
interest, short enough so stocks do not change.
▪IS-LM equilibrium is not permanent. S>0 implies that wealth
(allocations) are increasing over time. Therefore LM is shifting due to
the stock of bonds. If net investment is positive, then the capital stock
grows.
43
The IS-LM Model
▪Equilibrium in the goods market
implies that an increase in the interest
rate leads to a decrease in output.
▪Equilibrium in financial markets
implies that an increase in output leads
to an increase in the interest rate.
▪When the IS curve intersects the LM
curve, both goods and financial
markets are in equilibrium.
44
Structure of the IS-LM Model
The IS-LM Model
Macroeconomic
equilibrium and policy
The intersection of IS and

LM represents the
simultaneous equilibrium
on the goods and the
money market for a given
value of government
spending G, taxes T, money
supply M and prices P
46
IS-LM Model: The Effects of a Monetary Expansion
▪Monetary contraction, or monetary
tightening, refers to a decrease in the
money supply.
▪An increase in the money supply is
called monetary expansion.
▪Monetary policy does not affect the
IS curve, only the LM curve. For
example, an increase in the money
supply shifts the LM curve down.
▪Monetary expansion leads to higher
output and a lower interest rate.
47
The IS-LM Model: Changes in the Equilibrium
Levels of Income and the Interest Rate
The equilibrium levels of income and
the interest rate change when either
the IS or the LM curve shifts
The Figure shows effects of an increase
in autonomous spending
Shifts IS curve out by 𝒂𝑮 ∆𝑰 if
autonomous investment is the source of
increased spending
The resulting change in Y is smaller than
the change in autonomous spending
due to slope of LM curve.
48
The IS-LM Curve: Deriving
the AD Schedule
•The AD schedule maps out the IS-LM
equilibrium holding autonomous spending
and the nominal money supply constant
and allowing prices to vary
•Assume, prices increase from P1 to P2
–M/P decrease from M/P1 to M/P2 → LM
decreases from LM1 to LM2
–Interest rates increase from i1 to i2, and
output falls from Y1 to Y2
–Corresponds to lower AD
49
The IS-LM Model: Macroeconomic equilibrium and policy
50
The IS-LM Model: Explaining the Liquidity Trap
51
IS-LM Model in the Long Run
52
IS-LM Model: Using a Policy Mix
The combination of monetary The Effects of Fiscal and Monetary Policy.
and fiscal polices is known as the
monetary-fiscal policy mix, or Shift of Shift of Movement Movement in
simply, the policy mix. IS LM of Output Interest Rate
Increase in taxes left none down down
Decrease in taxes right none up up
Increase in spending right none up up
Decrease in spending left none down down
Increase in money none down up down
Decrease in money none up down up
53
The IS-LM Model and the Facts
We can describe the basic mechanisms as below:
▪Consumers are likely to take some time to adjust their
consumption following a change in disposable income.
▪Firms are likely to take some time to adjust investment spending
following a change in their sales.
▪Firms are likely to take some time to adjust investment spending
following a change in the interest rate.
▪Firms are likely to take some time to adjust production following
a change in their sales.
54
IS-LM Model: Merits and Demerits
Advantages Disadvantages
1. This model is widely used and seen as useful in gaining an 1. This model ignores uncertainty – and
understanding of macroeconomic theory even though disputed that liquidity preference only makes
in some circles and considered to be imperfect . sense in the presence of uncertainty.
2. It is used in most college macroeconomics textbooks. 2. A shift in the IS or LM curve will cause
3. Most modern macroeconomists see the IS-LM model as being change in expectations, causing the
at best a first approximation for understanding the real world. other curve to shift.
4. IS-LM can be used to assess the impact of exogenous shocks on 3. Takes a simplistic approach to fiscal
the endogenous variables of the model (interest rates and policy, the money market, and money
output) supply.
5. One can also evaluate the effectiveness of the policy mix, i.e. 4. Does not take into account a huge
the combination of: variety of factors the come to play in the
▪ Fiscal policy: changes to government spending and taxes modern economy, such as international
▪ Monetary policy: changes to money supply trade, demand, and capital flows
55
Key words
Product Market
Money Market
Product and Money Market
Equilibrium
IS curve
LM curve
IS-LM Model
56
Thank you.
That’s all for
this session!

Open Economy Framework:
International Trade
Professor
International Trade
International Trade – is the cross-border
import and export of goods and services
among the nations.
Imports – are goods and services
purchased from other countries.
Exports – are goods and services sold to
other countries.
The underlying principle of international
trade is the economic interdependence.
2
World Trade
3
International Trade
Advantages Examples
High-quality goods Electronics; scientific products; cars
Lower prices Clothing and textiles
Larger profits McDonalds, KFC
Higher employment China, India
Improved Standard of Living China, India
More purchasing options Developed nations like the U.S
4
Domestic vs. International Trade
Domestic Trade International Trade
1. A domestic trade is an internal trade 1. International trade or foreign trade
which is within the borders of a given on the other hand is any business
country. For example, all trading transaction that occurs between two
activities that go on within your or more countries across the border.
country are referred to as domestic 2. Involves use of largely foreign
trade. currencies.
2. Involves use of largely the local 3. Subjected to certain restrictions such
currency. as embargoes and quotas
3. Largely free from restrictions 4. World Trade Organization (WTO)
4. Not regulated by external bodies regulates
5
Theories of International Trade
Theory of Comparative Theory of Factor The Product Porter’s
Absolute Advantage Reciprocal Demand Endowment Life Cycle Theory of
Advantage Theory Theory Theory National
Diamond
Adam Smith David Ricardo John Stuart Mill (1806- Heckscher (1919) Raymond Vernon Michel Porter
(1776) Cost (1817) 1873) - Olin (1933) (1966) (1990)
differences The basic Reciprocal Demand Theory Theory: Focuses on the 1. Factor
govern prediction of states that within the The resource role of endowments
international Ricardo’s principle outer limits of terms of endowments are technological 2. Firm strategy,
movement of is that countries trade, the actual terms of the key innovation as a structure and
goods and will tend to export trade is determined by the determinants of key determinant rivalry
services those goods in relative strength of each comparative of trade patterns 3. Demand
Smith’s concept which their labor country’s demand for advantage. in manufactured conditions
of cost was productivity is other country’s product. goods. 4. Related and
founded upon the relatively high. Terms of trade is the ratio of an supporting
index of a country's export prices
labor theory of to an index of its import prices.
industries
value.
6
Theory of Absolute Advantage
1. In a two nation, two product world, international specialization and
trade will be beneficial when one nation has absolute cost
advantage in one good and the other nation has absolute cost
advantage in another good.
2. A nation will import those goods in which it has absolute cost
disadvantage and export those goods in which it has absolute
cost advantage.
3. Free trade benefits a nation as a whole, but individuals may lose
jobs and incomes from the competition from foreign goods and
services.
Absolute Advantage Principle
Consider world output possibilities in the absence of
specialization.
Country Wine Cloth
United States 5 bottles 20 yards
United Kingdom 15 bottles 10 yards
US has absolute advantage in cloth production
UK has absolute advantage in wine production
Comparative Advantage Principle
1. Even if a nation has an absolute cost advantage in the production of both
goods, a basis for mutually beneficial trade may still exist.
2. The less efficient country should specialize in and export the good in which
it is relatively less inefficient.
3. The more efficient country should specialize in and export that good in
which it is relatively more efficient (where its absolute advantage is
greatest).
4. When nations follow the principle of comparative advantage, they gain. The
reason is that world output increases and each nation ends up with a higher
standard of living by consuming more goods and services than possible
without specialization and trade.
Comparative Advantage
Country Output per labor hour
Wine Cloth
United States 40 bottles 40 yards
Unite Kingdom 20 bottles 10 yards
According to Ricardo’s Comparative Advantage theory,
1. US should specialize in and export cloth where it has comparative
advantage, and
2. UK should specialize in and export wine in which it has smaller absolute
disadvantage.
Protectionism
Countries use protectionist measures to shield a country’s markets from
intrusion by foreign competition and imports.
1. Maintain employment and reduce unemployment.
2. Increase of business size, and
3. Retaliation and bargaining.
4. Protection of the home market / Protect sunrise industries / Help the environment
5. Need to keep money at home.
6. Encouragement of capital accumulation.
7. Maintenance of the standard of living and real wages.
8. Conservation of natural resources /Protect strategic industries
9. Protection of an infant industry / Protect non-renewable resources
10. Industrialization of a low-wage nation / Deter unfair competition
11. National defense
11
New Protectionism
1. Government favouring domestic firms
2. Domestic subsidies
3. Health and safety grounds
4. Quality standards
5. Bureaucracy
6. Exchange rates
12
Trade barriers
1. Import duties
2. Import quotas
3. Import licenses
4. Tariffs
5. Embargos
6. Export licenses
7. Subsidies
8. Non-tariff barriers to trade
9. Voluntary Export Restraints
13
Tariffs
▪A tariff is a tax on imports or exports.
▪Money collected under a tariff is called a duty or customs duty.
▪Tariffs are used by governments to generate revenue or to
protect domestic industries from competition.
▪Why impose tariff?
1. To discourage consumption Pros Cons
Domestic industries Consumers pay
2. To raise revenue
are protected higher prices
3. To discourage imports create more Hurts international
4. To protect domestic industries domestic jobs relationship
14
Tariffs
Ad valorem Tariffs Specific Tariff Compound Tariff
Ad valorem tariffs are calculated as a fixed A specific tariff is a fixed Compound tariffs
percentage of the value of the imported amount of money that include both ad
good. The most common is an ad valorem does not vary with the valorem and a specific
tariff, which means that the customs duty is price of the good. component.
calculated as a percentage of the value of
the product. A per unit tax on imports For example, A country
charges Rs. 0.88 per
A value based tax on imports In some cases, both liter of some petroleum
the ad valorem and products plus 25
When the international price of a good rises specific tariffs are levied percent ad valorem.
or falls, so does the tariff. on the same product.
15
Tariffs..
Most Favored Nation (MFN) Tariff Preferential Tariff Bound Tariff (BND)
1. MFN tariffs are what countries 1. These agreements are 1. Bound tariffs are specific
promise to impose on imports reciprocal: all parties agree commitments made by
from other members of the WTO, to give each other the individual WTO member
unless the country is part of a benefits of lower tariffs. governments.
preferential trade agreement 2. Some agreements 2. The bound tariff is the
(such as a free trade area or specify that members will maximum MFN tariff level for a
customs union). receive a percentage given commodity line.
2. This means that, in practice, reduction from the MFN 3. When countries join the WTO
MFN rates are the highest (most tariff, but not necessarily or when WTO members
restrictive) that WTO members zero tariffs. negotiate tariff levels with each
charge one another. 3. Preferences therefore other during trade rounds, they
differ between partners make agreements about bound
and agreements. tariff rates, rather than actually
applied rates. 16
The Impact of Tariffs - Higher prices
Domestic consumers face higher prices, which also
means that there is a loss of consumer surplus.
Without trade, the domestic price and quantity are P & Q.
When world supply is allowed, price falls to P1, and

output increases from Q to Q2. As a result, domestic
producers’ share falls to Q1 and imports now dominate,
with the quantity imported Q1 to Q2.
The imposition of a tariff shifts up the world supply curve

to World Supply + Tariff.
The price rises to P2, and the new output is at Q3.

Domestic producers share of the market rise to Q4, and
imports fall to Q4 to Q3. The result is that domestic
producers have been protected from cheaper imports
from the rest of the World.
17
Trade Protectionism
18
The Impact of Tariffs - Welfare loss
The reduction in consumer surplus is
greater than the increase in producer
surplus.
Even when adding the tariff revenue

(area K,L,M,N) there is still a net loss.
The net welfare loss is represented
by the triangles X and Y.
19
Quotas
▪A quota is a limit to the quantity coming into a
country.
▪Quota enables the domestic share of output to
rise to 0 to Q2, plus Q3 to Q4.
▪The quota creates a relative shortage and
drives the price up to P2, with total output
falling to Q4. The amount imported falls to the
quota level. It is this price rise that provides an
incentive for less efficient domestic firms to
increase their output.
▪One of the key differences between a tariff and
a quota is that the welfare loss associated with
a quota may be greater because there is no tax
revenue earned by a government. Because of
this, quotas are less frequently used than
tariffs.
20
Inducing Exports with a Domestic
Production Subsidy
suppose that the government
of this country offers a
specific (per unit) production
subsidy to the domestic
firms.
Let the subsidy rate be set at
“s.” This means the
government will pay “s”
dollars for every unit the
domestic firm produces,
regardless of where the
product is sold.
The new producer price is
labeled PP
PP = PFT + s and PC = PFT
21
▪A trade war is an economic conflict between countries that involves implementing
protectionist policies in the form of trade barriers.
▪A trade war is when a nation imposes tariffs or quotas on imports and foreign countries
retaliate with similar forms of trade protectionism. As it escalates, a trade war reduces
international trade.
▪Trade barriers used in trade wars include tariffs, import quotas, domestic subsidies,
currency devaluation, and embargos
▪In the short term, trade barriers can protect industries. However, over the long term, they
usually turn out to be negative for the economy overall.
▪Devaluing the domestic currency in relation to foreign currency can also be used as a
trade war tactic. By lowering the exchange rate, domestic exports become more
competitive in other countries. At the same time, imports from other countries become
relatively more expensive and less competitive in the domestic marketplace. 22
23
How China Affects the U.S. Economy
▪China is the second-
largest foreign holder of
U.S. Treasurys. As of
August 2020, it owned
$1.07 trillion in Treasurys,
around 15% of the public
debt held by foreign
countries.15
▪ The U.S. debt to China is
lower than the record high
of $1.7 trillion held in
2011.16
▪China buys U.S. debt to
support the value of the
dollar. This is because
China pegs its currency,
the yuan, to the U.S.
dollar. It devalues the
currency when needed to
keep its export prices
competitive.
24
WTO
There are a number of ways of looking
at the WTO
It’s an organization for liberalizing
trade.
It’s a forum for governments to
negotiate trade agreements. It’s a
place for them to settle trade
disputes. It operates a system of
trade rules.
It’s a negotiating forum …
Geneva
It’s a set of rules …
And it helps to settle disputes …
WTO
What is WTO?
A simple answer: “A global organization dealing with rules of trade
between nations”.
The World Trade Organisation (WTO)
Established on 1st January 1995
As a result of the Uruguay Round negotiations (1986-1994)
Located in Geneva, Switzerland
Members: 164 members (29 July 2016)
India is a member - 1 January 1995 (GATT: 8 July 1948)
What is the Predecessor of the WTO?
The General Agreement on Tariffs and Trade (GATT) 1947 -the first major
effort to establish international rules governing trade in goods. Though
initially conceived as a provisional legal instrument, it endured for almost 50
years.
Principles of the world trading system under the WTO
1. Non discrimination- Most Favoured Nation (MFN) and National

Treatment obligations
2. Freer trade – negotiations aimed at lowering trade barriers
3. Predictability and transparency - binding commitments, restrictions on
the use of barriers to trade and transparent trade policies and
regulatory frameworks (e.g. transparency obligations in the major trade
agreements and the Trade Policy Review Mechanism)
4. The promotion of fair competition - MFN, national treatment and rules
against unfair trade practices (e.g. anti dumping)
5. Encouragement of development and economic reform
Organizational Structure of WTO
1. Ministerial Conference- The apex body for decision making (meets every 2 years).
Composition:-ministerial representatives.
2. General Council- performs the functions of the Conference between meetings and has specific
duties assigned to it by the WTO agreements. Composition:- governmental representatives.
3. The General Council also meets as the Dispute Settlement Body and the Trade Policy Review
Body.
4. Councils for Trade in Goods (oversees GATT), Trade in Services (oversees GATS) and TRIPS
which report to and assist the General Council. [GATT: General Agreement on Tariffs and Trade; GATS: General Agreement on
Tariffs and Services; TRIPS: Agreement on Trade-Related Aspects of Intellectual Property Rights]
5. Committees on special subjects, Committees functioning under the Councils and Committees
for the Plurilateral Agreements.
Membership- developed, developing, least developed countries and economies in transition.
Decision making is by consensus. If consensus is not possible decisions will be taken by a majority
vote.
Trade Policy Review Mechanism
◦ The trade policy review mechanism scrutinizes the trade policy
of each member state on a regular basis.
◦ The report on the four major trading partners ( US, EU ,Japan
and Canada) are provided more frequently.
◦ This review is expected to exercise discipline on the trade policy
of member states.
Key words
International trade
Domestic trade
Absolute advantage
Comparative Advantage
Protectionism
Tariffs
Barriers
WTO
30
Thank you.
That’s all for
this session!

Open Economy
Framework:
Foreign Exchange
Professor
2
Coverage
1. Fixed exchange rate
2. Floating exchange rate
3. Managed floating exchange rate
4. Nominal exchange rate
5. Real exchange rate
6. Effective Exchange rate
7. Determination of Exchange Rate
8. Factors influencing exchange rate
9. Participants of Foreign Exchange Markets.
3
Introduction
Economies are linked through two broad channels
1. Trade
◦ Some of a country’s production is exported to foreign countries → increase
demand for domestically produced goods
◦ Some goods that are consumed or invested at home are produced abroad
and imported → a leakage from the circular flow of income
2. Finance
◦ Portfolio managers shop the world for the most attractive yields
◦ As international investors shift their assets around the world, they link
assets markets here and abroad → affect income, exchange rates, and the
ability of monetary policy to affect interest rates
◦ U.S. residents can hold U.S. assets OR assets in foreign countries
4
Exchange Rates
▪Exchange rate is the price of one currency in terms of
another
▪Ex. On 24th Jan 2019 you could buy 1 USD for INR 71.22 in
Indian currency → nominal exchange rate was e = 71.22
▪If a sandwich cost 2.39 USD, that is equivalent to
▪71.22(INR/USD)x2.39USD=USD 170.21
5
Nominal Exchange Rate
1. Relative price of two currencies
2. It is often expressed as number of units of local or home currency required to buy a unit
of foreign currency
3. We usually view Indian Rupee (INR) as our home currency and United States Dollar
(USD) as our foreign currency
local currency INR
4. Nominal or currency exchange rate (e) is
e= =
foreign currency USD
5. If e increases, the value of INR (home currency) falls

6. If e decreases, the value of the INR (home currency) rises (nominal appreciation)
7. e and the value of INR are inversely related
8. e is often graphed as its inverse which is equal to the value of INR
VIGHNESWARA SWAMY
Nominal Exchange Rate
The nominal exchange rate is the price of one country’s
exchange rate in terms of another’s.
Example:
In India, if you want to buy a dollar, it costs 50 Rupees on the
market.
1. So, the nominal exchange for dollars is 1/50=.02 dollars
per rupee in India.
2. In the U.S, the nominal exchange rate for a rupee is 50
rupees to the dollar.
VIGHNESWARA SWAMY
The Real Exchange Rate
1. Measures the rate at which two countries’ goods trade against
each other
2. Makes use of the price levels in the two countries under
consideration
◦ PIND—overall price level in India (the home country)
◦ PUS—overall price level in the United States (the foreign country)
◦ Then Real Exchange Rate (re):
US
P
re = e  IND
P
VIGHNESWARA SWAMY
Real Exchange Rate
The real exchange rate is the purchasing power of a currency
relative to the purchasing power of other currencies.
Things cost different amounts in each country.
For example:
To take the Indian case, with INR 67 to 1USD.
A shirt in India may cost INR 670, while in the U.S it costs USD10.
Are you better off buying in India or in the U.S? To check, we have to calculate the real
exchange rate
VIGHNESWARA SWAMY
Real Exchange Rate
Formula:
[Bilateral Real ER= Nominal ER (Foreign Price /Domestic Price)]
EX r is the Real Exchange Rate
EX n is the nominal Exchange Rate
Pd is the Domestic Price
Pf is the Foreign Price
[Real E.R= 71.22 x (12USD/500INR)=1.70]
VIGHNESWARA SWAMY
Real Exchange Rate
From the previous example:
Consider the Indian case with INR 67 to 1USD. A shirt in India may cost INR
445, while in the U.S it costs USD12.
Are you better off buying in India or in the U.S?

To check, we have to calculate the real exchange rate.
EX r = [INR 67/1USD]x[USD12]/445
= [67]x[12] /445 = 1.80
That means 2 Indian shirts / 1 US shirt.
So, shirts are in real terms, twice as expensive in the U.S as they are in India.
VIGHNESWARA SWAMY
Real Exchange Rate
▪The RER between two currencies is the product of the
nominal exchange rate (the INR cost of a USD, for example)
and the ratio of prices between the two countries.
▪ Consider an example:
▪Nominal Exchange Rate (NER)=1USD=INR 71
▪Price of Big Mac in USA = USD 2.51
▪ Price of Big Mac in India = USD 3.57
▪RER = 71 (2.51/3.57)= 49.91
12
Real Effective Exchange Rate (REER)
▪Real Effective Exchange Rate (REER) is a measure of the trade-weighted average exchange rate
of a currency against a basket of currencies after adjusting for inflation differentials with regard
to the countries concerned and expressed as an index number relative to a base year.
▪REER is also defined as the average of the bilateral Real Exchange Rates (RER) between the
country and each of its trading partners, weighted by the respective trade shares of each
partner.
▪Real Effective Exchange Rates are used for an array of purposes such as:
1. assessing the equilibrium value of a currency
2. the change in price or cost competitiveness
3. the drivers of trade flows
4. incentives for reallocation production between the tradable and the non-tradable sectors.
13
Real Effective Exchange Rate (REER)
𝑹𝑬𝑬𝑹𝑪𝒐𝒖𝒏𝒕𝒓𝒚 𝒊=
𝑵
= ෍𝑻𝒓𝒂𝒅𝒆 𝒘𝒆𝒊𝒈𝒉𝒕 𝑪𝒐𝒖𝒏𝒕𝒓𝒚 𝒋

𝒋=1
× 𝑹𝒆𝒂𝒍 𝑬𝒙𝒄𝒉𝒂𝒏𝒈𝒆 𝑹𝒂𝒕𝒆 (𝑪𝒐𝒖𝒏𝒕𝒓𝒚 𝑱ሻ
country j=1,2,...N are country i's trading partners, exchange rates in natural
logarithms (geometric averages)
14
Fixed Exchange Rates
In a fixed exchange rate system, central banks buy and sell
their currencies at a fixed price in terms of dollars
◦ Ensures that market prices equal to the fixed rates
➢No one will buy dollars for more than fixed rate since they know that
they can get them for the fixed rate
➢No one will sell dollars for less than fixed rate since know can sell them
for the fixed rate
Central banks hold reserves to sell when they have to intervene in
the foreign exchange market
◦ Intervention: the buying or selling of foreign exchange by the central bank
15
Central Bank Intervention in Forex Market
What determines the level of intervention of a central bank in a fixed
exchange rate system?
Under a fixed exchange rate, price fixers must make up the excess demand or take up the excess
supply
Makes it necessary to hold an inventory for foreign currencies that can be provided in exchange
for the domestic currency
If a country persistently runs deficits in the balance of payments:

◦ The central bank eventually will run out of reserves on of foreign exchange
◦ Will be unable to continue its intervention
◦ Before this occurs, the central bank will likely devalue the currency
16
Flexible Exchange Rates
In a flexible (floating) exchange rate system, central
banks allow the exchange rate to adjust to equate the
supply and demand for foreign currency
◦ Under a flexible exchange rate system, exchange rates can be
highly volatile and hard to predict.
◦ Monetary policy can be used to stabilize the economy.
◦ Given nominal price rigidities, flexible exchange rates help
economy adjust more quickly.
17
The Flexible Exchange Rate Regime:
1973-Present
Free Float
The largest number of countries, about 48, allow market forces to determine their currency’s value.
Managed Float
About 25 countries combine government intervention with market forces to set exchange rates.
Pegged to another currency

Such as the U.S. dollar or euro (through franc or mark).
No national currency
Some countries do not bother printing their own currency. For example, Ecuador, Panama, and El
Salvador have dollarized. Montenegro and San Marino use the euro.
The Flexible Exchange Rate Regime:
1973-Present ..
Currency Board: A legislative commitment to exchange domestic currency for a
specified foreign currency at a fixed ex rate.
Fixed Peg: The ex rate is fixed against a major currency. Active intervention
needed.
Crawling Peg: The ex rate is adjusted periodically in small amounts at a fixed,
preannounced rate. (Mexico pegged its Peso with USD)
Dollarization: The dollar circulates as the legal tender
The Determinants of Foreign Exchange Rates
VIGHNESWARA SWAMY
Factors
affecting
Exchange
Rates
21
A stronger Rupee (INR) dollar means …
India can buy foreign
goods more cheaply and
Indian imports will
increase
Foreigners find Indian

goods more expensive
and Indian exports fall
22
An increase in the interest rate in the USA
What will be the effect of an increase in the
interest rate in the US on the INR/USD?
S’fe
Foreign exchange rate is determined
Sfe
(ceterus paribus) by the availability of
71 73
quantity of foreign exchange. E’
Foreign exchange rate

E
In the figure, as the supply of foreign
exchange quantity of USD decreases due to
D’fe
INR/USD
the rise in interest rate in the US, the new
equilibrium shifts leftwards to E’. Then the Dfe
exchange rate moves up causing
depreciation of Indian currency (INR). Foreign exchange quantity (USD)
23
Forecasting Exchange Rates
1. Flow (BoP) Approach
2. Asset (Market) Approach
3. Portfolio Balance Approach
4. Efficient Markets Approach
5. Fundamental Approach
6. Technical Approach
7. Performance of the Forecasters
What is Foreign Exchange Market?
1. Foreign Exchange Market is a currency market where
money denominated in one currency is bought and sold
with money denominated in another currency.
2. It facilitates the conversion of one country’s currency into
another through the buying and selling of currencies.
3. It sets and quotes exchange rates and offers contracts to
manage foreign exchange exposure.
4. Essentially, foreign exchange market refers to the
organizational setting within which individuals, businesses,
governments, and banks buy and sell foreign currencies
and other debt instruments.
VIGHNESWARA SWAMY
Location of Forex Market
1. There is no physical location where traders get together to
exchange currencies.
2. Traders are located in the offices of major commercial banks
around the world and communicate using computer
terminals, telephones, telexes, and other information
channels.
3. Most trades happen by phone, telex, or SWIFT (Society for
Worldwide Interbank Financial Telecommunications)
4. The FX market is an over-the-counter market.
VIGHNESWARA SWAMY
Forex
Market
Structure
Participants
1. Central Banks
2. Commercial
Banks
3. Corporations
4. NBFCs
5. Exporters and
Importers
6. Retail Traders
VIGHNESWARA SWAMY
Facilitates
Exchange of
Currencies
Capital
Features
mobility 24 hour
of Forex
(Unrestricted market
Market
or Restricted)
Covered
interest
parity
relationship
VIGHNESWARA SWAMY
Forex Market Functions
1. The transfer of funds or purchasing power from one nation
and currency to another.
Demand for foreign currencies
-Import/expenditures abroad/investment abroad
Supply of foreign currencies
-Export/earnings from tourism/receipt of foreign investments
2. The credit function

3. Facilitates hedging and speculation
VIGHNESWARA SWAMY
Key words
Exchange rate
Nominal exchange rate
Real exchange rate
Effective exchange rate
Fixed exchange rate
Floating exchange rate
Managed float
30
Thank you.
That’s all for
this session!

Open Economy Framework:
Balance of Payments
Professor
Coverage
1.Balance of Payments
2.Current Account
3.Capital Account
4.Financial account
5.The effects of Crude oil /Gold price on Current account.
2
Balance of Payments
Balance of Payments (BOP)—is an accounting
record of all the economic transactions
between the residents of one country and the
rest of the world.
The nations keep the record of BoP on an
annual basis. Some nations like U.S. keep the
record of BoP on quarterly basis.
The BoP is the statistical record of a country’s
international transactions over a certain period
of time presented in the form of double-entry
bookkeeping.
VIGHNESWARA SWAMY
BoP – RBI Definition
The Balance Of Payments of a country is a systematic
record of all economic transactions between the ‘residents’
of a country and the rest of the world.
It presents a classified record of all receipts on account of
goods exported, services rendered and capital received by
‘residents’ and payments made by them on account of
goods imported and services received from the capital
transferred to ‘non-residents’ or ‘foreigners’.” – Reserve
Bank of India (RBI)
VIGHNESWARA SWAMY
Visible and Invisible Items
1. Visible Items: 2. Invisible Items:
1.These include all types of physical
goods which are exported and 1.Invisible items of trade refer to all
imported. types of services like shipping,
2.These are called ‘visible items’ as they banking, insurance etc., which are
are made of some matter or material given and received.
and can be seen, touched and 2.These are called invisible items as
measured.
they cannot be seen, felt, touched
3.The movement of such items is open
and can be verified by the customs
or measured.
officials.
VIGHNESWARA SWAMY
Unilateral Transfers and Capital
Transfers
Unilateral Transfers: Capital Transfers:
Unilateral transfers include gifts, Capital transfers relate to
personal remittances and other capital receipts (through
‘one-way transactions’. borrowings or sale of assets)
Since these transactions do not and capital payments (through
involve any claim for repayment, capital repayments or purchase
they are also known as of assets).
unrequited transfers.
VIGHNESWARA SWAMY
Features of the BOP
❖BOP follows the accounting procedure of double-entry bookkeeping (debits &
credits).
❖A credit entry records an item or transaction that brings foreign exchange into
the country.
❖A debit entry represents a loss of foreign exchange.
❖BOP will always balance.
❖A BOP deficit (surplus) means that the debit entries exceed (are less than) the
credits. This imbalance applies only to a particular account or component of
the BOP.
❖BOP is a flow statement, not a stock statement.
7
Why is it useful to examine BOP?
The BOP provides detailed information about
the supply and demand of the country’s
currency.
◦ The trade statistics in the Current Account, show
the composition of trade – what a country imports
and what it exports?
◦ The Capital Account shows inflows and outflows of
capital in various categories.
Viewed over time, BOP data can shed light on
important developments in a country’s
comparative advantage and international
competitiveness.
8
Significance of BoP
The BoP is an important indicator of pressure on a country’s foreign
exchange rate .
The BOP helps to forecast a country’s market potential, especially in

the short run.
Changes in a country’s BOP may signal the imposition or removal of

controls over payment of dividends and interest, license fees, royalty
fees, or other cash disbursements to foreign firms or investors.
9
BoP Accounting
Current Account
The current account of the Capital Account
balance of payments refers Capital Account includes
to the monetary value of transactions that are purely
international flows
associated with transactions claims on financial assets
in goods, services, income (i.e. purchases or sales of
flows, and unilateral financial assets).
transfers.
10
Balance of Payment
Current Account Capital Account
1.Merchandize Trade balance: 1. Foreign Investment:
- Exports - FDI, FPI, ADRs, GDRs,
- Imports
2. Invisibles: 2. Loans:
- Services Balance: - External assistance
Transportation, - Commercial Borrowing
Military transactions, - Short Term Funds
Royalties, Software
3. Unilateral Transfers: 3. Banking Capital
- Government Grants - Foreign assets of banks
- Private Transfers or remittances - Foreign liabilities of ADs
- Others
4. Other Capital
5. Reserve Account
6. Statistical discrepancy 11
Reserve Account
Reserve Account Statistical Discrepancy
Reserve Account constitutes the Statistical Discrepancy account
changes in the reserves indicated includes the errors and
separately. omissions.
These are the assets that are

acceptable across the world for
settlements of international
transactions.
12
Different Accounts …. In short
Current Account a record of all international transactions for goods and services.
The current account combines the transactions of the trade
account and the services account.
Merchandise a record of all international transactions for goods only. Goods
Trade Account include physical items like autos, steel, food, clothes,
appliances, furniture, et. al.
Services Account a record of all international transactions for services only.
Services include transportation, insurance, hotel, restaurant,
legal services, consulting, et. al.
Financial a record of all international transactions for assets. Assets
Account include bonds, treasury bills, bank deposits, stocks, currency,
real estate, et. al.
13
Standard Presentation of India's Balance of Payments
(US$ Million)
Apr-Jun 2018 PR Jul-Sep 2018 P Apr-Sep 2018 P
Credit Debit Net Credit Debit Net Credit Debit Net
1 Current Account (1.A+1.B+1.C) 155692171613 -15921 160007 179098 -19091 315699 350711 -35012
1.A Goods and Services (1.A.a+1.A.b) 131563 158619 -27057 133493 163277 -29784 265055 321896 -56840
1.B Primary Income (1.B.1to1.B.3) 5327 11244 -5917 5623 14282 -8659 10950 25526 -14576
1.C Secondary Income (1.C.1+1.C.2) 18803 1750 17053 20891 1539 19352 39694 3289 36405
2 Capital Account (2.1+2.2) 111 94 17 75 96 -21 186 190 -4
3 Financial Account (3.1 to 3.5) 142502125807 16695 131048 112851 18198 273551 238658 34893
3.1 Direct Investment (3.1A+3.1B) 17313 7453 9860 14997 7126 7872 32310 14579 17732
3.1.B Direct Investment by India 276 3619 -3344 751 3071 -2320 1027 6690 -5663
3.5 Reserve assets 11338 0 11338 1868 0 1868 13206 0 13206
3 Total assets/liabilities 142502 125807 16695 131048 112851 18198 273551 238658 34893
4 Net errors and omissions 792 -792 914 914 123 123
P: Preliminary. PR: Partially Revised.
14
India's Current Account
(US$ Million)
Current Account
1 (1.A+1.B+1.C) 155692171613 -15921 160007 179098 -19091 315699 350711 -35012
1.A Goods and Services (1.A.a+1.A.b) 131563 158619 -27057 133493 163277 -29784 265055 321896 -56840
1.A.a Goods (1.A.a.1 to 1.A.a.3) 83389 129141 -45752 83399 133432 -50034 166788 262574 -95786
1.A.b Services (1.A.b.1 to 1.A.b.13) 48174 29478 18696 50094 29844 20250 98268 59322 38946
1.B Primary Income (1.B.1to1.B.3) 5327 11244 -5917 5623 14282 -8659 10950 25526 -14576
1.C Secondary Income (1.C.1+1.C.2) 18803 1750 17053 20891 1539 19352 39694 3289 36405
15
India Current
Account - Services
What services bring current account surplus to
India?
The detailed analysis of service component of
current account deficit shows that the largest
component of India’s services surplus comes
from IT industries.
Similarly, India is a net exporter of travel
meaning foreigners visiting India spend more
money than Indians visiting foreign countries.
India has to send abroad a significant amount
of money for use of intellectual property.
India is a net importer of recreational services
that include services in film, music industry and
so on. 16
What Factors cause a current account deficit?
1.A current account deficit occurs when the value of imports (of goods,
services and investment incomes) is greater than the value of exports.
2.Running a Current Account Deficit means that an economy is not
paying its way in the global economy.
3.There is a net outflow of demand and income from the circular flow of
income and spending.
4.Spending on imported goods and services exceeds the income from
exports.
5.Decreasing a current account deficit is not in the hands of home
country alone.
17
What factors cause a current account deficit?
1. Exchange Rate
2. Economic Growth
3. Decline in Competitiveness
4. Higher inflation
5. Poor productivity
6. Low levels of investment in real capital
7. Low levels of investment in human capital
18
India's Capital Account (US$ Million)
2 Capital Account (2.1+2.2) 111 94 17 75 96 -21 186 190 -4
Gross acquisitions (DR.)/disposals (CR.) of non-
produced nonfinancial assets
2.1 66 16 51 2 4 -2 68 20 49
2.2 Capital transfers 45 78 -33 72 92 -19 118 170 -53
2.2.1 General government 1 22 -22 0 21 -21 1 43 -43
2.2.1.1 Debt forgiveness
2.2.1.2 Other capital transfers 1 22 -22 0 21 -21 1 43 -43
Financial corporations, nonfinancial
2.2.2 corporations, households, and NPISHs 44 56 -12 72 71 2 117 127 -10
2.2.2.1 Debt forgiveness
Other capital transfers including migrants
2.2.2.2 transfers 44 56 -12 72 71 2 117 127 -10
19
Capital Flows and BoP
In addition to Currency Depreciation and Protectionism,
another way of monitoring and arresting the adverse
Balance of Payments (BoP) is controlling the capital flows
on account of transactions of financial assets.
VIGHNESWARA SWAMY
India's Financial Account
(US$ Million)
3 Financial Account (3.1 to 3.5) 142502 125807 16695 131048 112851 18198 273551 238658 34893
3.1 Direct Investment (3.1A+3.1B) 17313 7453 9860 14997 7126 7872 32310 14579 17732
3.2 Portfolio Investment 60453 68598 -8145 60388 62006 -1618 120841 130604 -9763
Financial derivatives (other than
3.3 reserves) and employee stock options 3631 5113 -1482 5623 4344 1278 9254 9458 -204
3.4 Other investment 49767 44643 5124 48172 39374 8798 97939 84017 13922
3.5 Reserve assets 11338 0 11338 1868 0 1868 13206 0 13206

21
Twin Deficit Identity
The Relationship between a Country’s Government Budget
Deficit and Its Current Account Deficit.
To understand this identity it will be helpful to take a much

more careful look at the national income identity.
VIGHNESWARA SWAMY
Tit-Bits
Difference between Current Account Deficit and Fiscal Deficit
Fiscal Deficit Current Account Deficit

Fiscal Deficit is a percentage of Current Account Deficit occurs
the nation's GDP and can be when the country's imports are
considered as an economic greater than the country's
event in which the government exports of goods, services and
expenditure exceeds its revenue transfers.
VIGHNESWARA SWAMY
Tit-Bits
Difference between Current Account Balance and Trade Balance
Current Account Balance Trade Balance

Total Exports – Total Imports Merchandize Exports –
= > 0 means surplus BoP Merchandize Imports
= < 0 means deficit BoP = > 0 means surplus BoT
= < 0 means deficit BoT
Indicates the competitiveness on

the manufacturing sector
VIGHNESWARA SWAMY
Tit-Bits
Difference between Current Account Balance and Trade Balance
Current Account Balance Trade Balance

Total Exports – Total Imports Merchandize Exports –
= > 0 means surplus BoP Merchandize Imports
= < 0 means deficit BoP = > 0 means surplus BoT
= < 0 means deficit BoT
Indicates the competitiveness on

the manufacturing sector
VIGHNESWARA SWAMY
Tit-Bits
Difference between BoT and BoP
BoT BoP
The difference between A system of accounts that
exports and imports of goods measures transactions of goods,
services, income and financial
assets between domestic
households, businesses, and
governments and residents of the
rest of the world during a specific
time period
VIGHNESWARA SWAMY
The BoP crisis and its Implications
Economic Crisis in Argentina
A severe economic crisis engulfed
Argentina in 2002. Following the
collapse of its fixed exchange rate, a
financial crisis, and a government
default, real output shrank by 15%
and took years to regain its previous
peak, as poverty and unemployment
rates remained at high levels. The
country sank into an economic
depression worse even than those in
the 1930s, 1910s, and 1890s.
27
Globalization
Globalization
1. Globalization is a process of greater interdependence among countries and their
citizens.
2. OECD defines Globalization as a process of deeper economic integration
between countries and regions of the world.
3. For a common man, globalization means, residents of one country are more
likely to consume the products of other country, to invest in other country.
4. Globalization has two facets: (1) Globalization of Markets and (2) Globalization
of Production.
5. Globalization is also termed as the shrinkage of economic space.
VIGHNESWARA SWAMY
Globalization: Major Drivers
1. Emergence of global financial markets.
2. Emergence of the Euro as a global currency (beginning of 1999).
3. Trade liberalization (GATT and WTO) and economic integration
(EU, SAFTA)
4. Surge in privatization, public private participation (PPP)
5. Emergence of Multinational Corporations (MNCs) like GE,
Vodaphone, Toyota, Siemens, TATA, and others
VIGHNESWARA SWAMY
Waves of Globalization
1. First Wave of Globalization: 1870-1914
- Largely driven by European and American businesses
2. Second Wave of Globalization: 1945-1980
-Decline in trade barriers, specialization in manufacturing
3. Latest Wave of Globalization: 1980 onwards

- Outsourcing of technologies and labor
VIGHNESWARA SWAMY
Globalization of Finance
1. Rise in international financial instruments
2. International funds (mutual funds)
3. Emerging country funds
4. Hot money flows
VIGHNESWARA SWAMY
Tit-Bits
Difference Globalization of Markets and Globalization of Production
Globalization of Markets Globalization of Production

Globalization of markets refers to the fact The globalization of production refers to
that in many industries historically distinct the tendency among many firms to source
and separate national markets are merging goods and services from different locations
into one huge global marketplace. around the globe in an attempt to take
advantage of national differences in the
cost and quality of factors of production.
(labor, energy, land and capital)
VIGHNESWARA SWAMY
Key learnings
1. The merchandise trade balance measures exports minus imports of goods.
2. Net exports includes trade in services as well.
3. The current account includes net international factor income, taxes, and
transfers.
4. The current account is mirrored by an equal and opposite capital and financial
account measuring net asset transactions.
5. The net international investment position measures our current net claims on
the rest of the world.
6. The flow identity tells us that the current account reflects some combination of
personal saving, investment in plant and equipment, and the government deficit.
VIGHNESWARA SWAMY
Key words
Balance of Payments
Current Account
Capital Account
Financial Account
Current Account Deficit
Globalization
Financial integration
35
Thank you.
That’s all for
this session!


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Introduction

▪It concerns the business

DR. VIGHNESWRA SWAMY 3

Usefulness of Microeconomics: Usefulness of Macroeconomics:

DR. VIGHNESWRA SWAMY 4

2. The Justice Principle 5. The Good Governance Principle

3. The Planetary Boundaries

▪An inclusive green economy is an alternative to today's

DR. VIGHNESWRA SWAMY 11

▪Economic analysis is used in all decision making.

DR. VIGHNESWRA SWAMY 13

Macroeconomics focuses on:

DR. VIGHNESWRA SWAMY 15

DR. VIGHNESWRA SWAMY 16

DR. VIGHNESWRA SWAMY 18

DR. VIGHNESWRA SWAMY 19

b) Use of natural resources in a country

c) Economic behavior of the government

d) Regulation of market place

e) Behaviour of the entire economy

DR. VIGHNESWRA SWAMY 23

b) Use of natural resources in a country

c) Economic behavior of the government

d) Regulation of market place

e) Behaviour of the entire economy

DR. VIGHNESWRA SWAMY 24

d) Pricing of goods and services

DR. VIGHNESWRA SWAMY 25

d) Pricing of goods and services

DR. VIGHNESWRA SWAMY 26

DR. VIGHNESWRA SWAMY 27

DR. VIGHNESWRA SWAMY 28

e) Rest of the world

DR. VIGHNESWRA SWAMY 29

e) Rest of the world

DR. VIGHNESWRA SWAMY 30

b) International Monetary Fund

c) Monetary policy committee in RBI

d) Securities Exchange Board of India

e) Banks Board Bureau

DR. VIGHNESWRA SWAMY 31

b) International Monetary Fund

c) Monetary policy committee in RBI

d) Securities Exchange Board of India

e) Banks Board Bureau

DR. VIGHNESWRA SWAMY 32

Please take a look at the

In this chapter we will explore:

4.1 Indicators of macroeconomic activity and per-

1. The rate of growth of real national income.

4.1 Macroeconomic performance

The rate of growth in real GDP is calculated as follows:

Real GDPyear 2 − Real GDPyear 1

Economic growth: an increase in real GDP.

Rate of economic growth: the annual percentage change in real GDP.

$1, 781 − $1, 751

Example Box 4.1: Constructing a price index

University student weekly expenditure basket (Base year 2006)

(Cost of basket in 2011)/(Cost of basket in 2006) × 100 = ($87.20)/($80.50) × 100 = 108.3

Inflation: a persistent rise in the general price level.