What is Macroeconomics?

Its Origin
Scope of Macroeconomics
1. 2. 3. 4. 5. 6. 7. 8. 9. Theory of National Income. Theory of Employment. Theory of Money. Theory of General Price Level. Theory of Economic Growth. Theory of International Trade. Macro Theory of Distribution. Theory of Trade Cycles. Balance of Payments and Exchange Rates.

Scope of Macroeconomic Theory

Theory of Income and Employment

Theory of General Price Level and Inflation

Theory of Economic Growth

Macro theory of Distribution

Theory of Consumption function

Theory of Investment

Theory of Business Cycles

GROWTH

Macro Economic Concepts

BUSINESS CYCLES

UNEMPLOYMENT

INFLATION

Importance of Macroeconomics
1. Macroeconomic paradoxes show the importance of Macroeconomic analysis: The study of macroeconomics is important in its own sake, as it tells us how the economy as a whole works. We cannot obtain and derive laws governing macroeconomic variables such as national income, total employment, general price level by studying the microeconomic decisions of individual consumers, firms and industries. This is because what is true and valid in case of an individual firm or industry may not be valid for the economy as a whole. Important nature of Macroeconomic Issues: Macroeconomics is concerned with the study of issues and problems which are of vital importance for determining well-being of the people. Macroeconomic problems such as unemployment, inflation, instability of foreign exchange rate case a lot of human sufferings. Importance of Macroeconomics for Accelerating Economic Growth: Macroeconomics explains the factors which determine economic growth and brings out what causes slowdown in productivity growth. All the economic models explains the same.

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Understanding Business Cycles: Fluctuations in aggregate demand due to volatile nature of investment demand.
Formulating Governments Macroeconomic Policies: In formulating the monetary and fiscal policies of the government. Individual Decision-making: The understanding about the working of the economy as a whole helps the individuals to take better decisions. The individuals can take care of situations like saving during inflation, investment during interest rise etc. Buying a new asset-whether it is the right time or not. Importance in Business Decisions: The changes in domestic business environment and the changes in International business environment can have a great impact in business decisions of investors and business houses.

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Limitations of Macroeconomics
1. Many propositions which are true for either individuals or for small groups of individuals or for small groups of individuals turn out to be false when the economy as a whole is considered. The Macroeconomic approach, which focuses attention on the large aggregates, often treats these aggregates as homogeneous forgetting the significance of the internal composition and structure of such aggregates. The utility of Macroeconomic analysis is further restricted by the fact that the bulk of the macroeconomic theory developed so far has relevance to the developed countries since most macroeconomic models have been constructed to approximate reality in the developed countries.

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 Gross Domestic Product (GDP): It measures total income of everyone in the economy. GDP also measures total expenditure on the economys output of goods and services.
For the economy as a whole, income equals expenditure, because every dollar of expenditure by a buyer is a dollar of income for the seller.

Income and Expenditure

 It is a simple depiction of the macroeconomy. It illustrates GDP as spending, revenue, factor payments, and income.
Factors of production are inputs like labor, land, capital, and entrepreneur. Factor payments are payments to the factors of production (e.g., wages, rent).

The Circular-Flow Diagram

FIGURE 1: The Circular-Flow Diagram

Households: own the factors of production, sell/rent them to firms for income buy and consume g&s Firms

Households

FIGURE 1: The Circular-Flow Diagram

Firms Firms: buy/hire factors of production, use them to produce g&s sell g&s

Households

FIGURE 1: The Circular-Flow Diagram

Revenue (=GDP) G&S sold

Markets for Goods & Services

Spending (=GDP) G&S bought

Firms
Factors of production Wages, rent, profit (=GDP)

Households
Labor, land, capital Income (=GDP)

Markets for Factors of Production

What This Diagram Omits The government

collects taxes purchases goods and services (g&s)

The financial system

matches savers supply of funds with borrowers demand for loans

The foreign sector

trades g&s, financial assets, and currencies with the countrys residents

Gross Domestic Product (GDP) Is

the market value of all final goods & services produced within a country in a given period of time.
Goods are valued at their market prices, so:

GDP measures all goods using the same units (e.g.,

dollars in the U.S.), rather than adding apples to oranges.

Things that dont have a market value are excluded,

e.g., housework you do for yourself.

Gross Domestic Product (GDP) Is

the market value of all final goods & services produced within a country in a given period of time.
Final goods are intended for the end user.

Intermediate goods are used as components or ingredients in the production of other goods.
GDP only includes final goods, as they already embody the value of the intermediate goods used in their production.

Gross Domestic Product (GDP) Is

the market value of all final goods & services produced within a country in a given period of time.
GDP includes tangible goods (like DVDs, mountain bikes, beer)

and intangible services (dry cleaning, concerts, cell phone service).

Gross Domestic Product (GDP) Is

the market value of all final goods & services produced within a country in a given period of time.
GDP includes currently produced goods, not goods produced in the past.

Gross Domestic Product (GDP) Is

the market value of all final goods & services produced within a country in a given period of time.
GDP measures the value of production that occurs within a countrys borders, whether done by its own citizens or by foreigners located there.

Gross Domestic Product (GDP) Is

the market value of all final goods & services produced within a country in a given period of time.
usually a year.

The Components of GDP

Recall: GDP is total spending. GDP has four components:
Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX)

These components add up to GDP (denoted Y):

Y = C + I + G + NX

 is total spending by households on g&s. Note on housing costs:

For renters, consumption includes rent payments. For homeowners, consumption includes the imputed rental value of the house, but not the purchase price or mortgage payments. See the footnotes on the next slide for more details.

Consumption (C)

 is total spending on goods that will be used in the future to produce more goods.

Investment (I)

includes spending on:

capital equipment (e.g., machines, tools) structures (factories, office buildings, houses) inventories (goods produced but not yet sold) Note: Investment does not mean the purchase of financial assets like stocks and bonds.

 is all spending on the g&s purchased by govt at the federal, state, and local levels.
G excludes transfer payments, such as Social Security or unemployment insurance benefits. These payments represent transfers of income, not purchases of goods & service.

Government Purchases (G)

Net Exports (NX)

NX = exports imports Exports represent foreign spending on the economys g&s. Imports are the portions of C, I, and G that are spent on g&s produced abroad. Adding up all the components of GDP gives:
Y = C + I + G + NX

Real versus Nominal GDP

Inflation can distort economic variables like GDP, so we have two versions of GDP: One is corrected for inflation, the other is not. Nominal GDP values output using current prices. Nominal GDP is not corrected for inflation. Real GDP values output using the prices of a base year. Real GDP is corrected for inflation.

The GDP Deflator

The GDP deflator is a measure of the overall level of prices. Definition:
nominal GDP GDP deflator = 100 x real GDP

One way to measure the economys inflation rate is

to compute the percentage increase in the GDP deflator from one year to the next.

GDP and Economic Well-Being

Real GDP per capita is the main indicator of the average persons standard of living.

Most economists, policymakers, social scientists, and businesspersons use a countrys real GDP per capita as the main indicator of the average persons standard of living in that country.
But GDP is not a perfect measure of well-being.

GDP is not a perfect measure of well-being

Much of what Robert Kennedy said about GDP is correct.

GDP does not value the quality of the environment.

GDP does not value leisure time. GDP does not value non-market activity, such as the child care a parent provides his/her child at home. GDP does not value an equitable distribution of income.

Then Why Do We Care About GDP?

Having a large GDP enables a country to afford better schools, a cleaner environment, health care, etc. In short, GDP does not directly measure those things that make life worthwhile, but it does measure our ability to obtain the inputs into a worthwhile life. Many indicators of the quality of life are positively correlated with GDP. For example

GDP and Life Expectancy in 12 Countries

Life expectancy 85 (in years)
80 75
Indonesia China Mexico Brazil India Russia Germany

90
Japan U.S.

70 65 60 55 50 $0

Pakistan Bangladesh Nigeria

$10,000

$20,000

$30,000

$40,000

Real GDP per capita, 2002

GDP and Adult Literacy in 12 Countries

Adult 100 Literacy (% of 90 population) 80
70 60 50 40
Bangladesh Russia

China

Mexico

Japan

U.S.

Brazil Indonesia Nigeria India Pakistan

Germany

30 $0 $10,000 $20,000 $30,000 $40,000

Real GDP per capita, 2002

GDP and Internet Usage in 12 Countries

Internet Usage (% of population)
60
U.S.

50
Japan

40

Germany

30 The lowest-income countries are all clustered near the 20 origin, so their names dont all fit on the graph. 10 0 $0

China

Mexico Brazil Russia

$10,000

$20,000

$30,000

$40,000

Real GDP per capita, 2002

National Income
Some countries are rich, some are poor and yet some others are in between. How do we measure the performance of an economy? Performance of an economy is related to the level of production (of goods and services) or total economic activity. Measures of national income and output are used in economics to estimate the total value of production in an economy. The standard measures of income and output are Gross National Product (GNP), Gross Domestic Product (GDP), Gross National Income (GNI), Net National Product (NNP), and Net National Income (NNI). In India, the Central Statistical Organization has been estimating the national income. National income per person or per capita income is often used as an indicator of peoples standard of living or welfare. However, many development economists have criticized that GNP as a measure of welfare has many limitations. They argued that human well-being does not depend on national income alone. As measures of GNP exclude poverty, literacy, public health, gender equity, and many human issues of well-being, they developed other measures of welfare such as the Human Development Index (HDI). Some rich countries in terms of national income are poor in human development. Similarly, poor countries in terms national income have performed well in human development. In the case of India, though the GDP is growing faster, its performance in terms of HDI is far below than that of many countries.

National Income Accounting

National income of a country can be defined as the total market value of all final goods and services produced in the economy in a year. Two things must be noted in regard to the meaning of National Income. First, it measures the market value of annual output. In other words national income is a monetary measure. Secondly, for calculating national income accurately all goods and services produced in any given year must be counted only once. Thus the total value of all final goods and services produced by various productive firms or businesses in a year is known as national product. Wages Value of Final + National Product= Goods and Services = Rent =National Income Produced + Interest + Profits

National Income and Related Concepts

GROSS DOMESTIC PRODUCT (GDP): Gross domestic product is the total money value of all final goods and services produced in an economy during a particular year by normal residents as well as non-residents in the domestic territory of a country but excludes the incomes received from abroad. GDP=Money Value of all Final Goods and Services Produced by National Residents + Income Earned Locally by ForeignersIncome Received by Nationals Abroad. We can think of actual GDP and potential GDP. Actual GDP means what the economy produces while Potential GDP represents what the economy could produce. GDP can be computed both at factor cost as well at market price. GDP at factor cost provides an estimate of the total value of final goods and services produced during a year at cost of production. For computing GDP at market price, all final goods and services are valued at their market prices and the values thus obtained are added.

The market price of goods include indirect taxes such as sales tax and excise duty. GDPMP =GDPFC + Indirect Taxes Subsidies GDPFC=GDPMP Indirect Taxes + Subsidies
GROSS NATIONAL PRODUCT (GNP): Gross National Product is defined as the total money value of all final goods and services produced in an economy during a particular year plus net income from abroad. GNP=Money Value of Final Goods and Services (both consumer and capital) + Income Earned by National Residents in Foreign Countries--Income Earned Locally but Accruing to Foreigners. The difference between GDP and GNP is due to net factor income from abroad. GNPMP=GNPFC + Indirect Taxes -- Subsidies GNPFC=GNPMP Indirect Taxes + Subsidies

Relation between different concepts of National Income

1. Gross Domestic Product Market Value of Final Goods and Services produced within the domestic territories. (+) Net Factor Income from Abroad = 2. Gross National Product (--) Depreciation = 3. Net National Product at Market Price (--) Net Factor Income from Abroad = 4. Net Domestic Product at Market Price (--) Net Indirect Taxes (i.e. Indirect Taxes minus Subsidies) = 5. Net Domestic Product at Factor Cost or Domestic Income (+) Depreciation = 6. Gross Domestic Product at Factor Cost (+) Net Factor Income from Abroad

= 7. Gross National Product at Factor Cost (--) Depreciation = 8. Net National Product at Factor Cost or National Income (--) Property and Entrepreneurial Income of the Government (--) Savings of Non-Departmental Enterprises (--) Social Security Contributions (--) Net Factor Income from Abroad = Income from Domestic Product Accruing to Private Sector (+) Interest on National Debt (+) Transfer Earnings from the Government (+) Current Foreign Transfer Payments (+) Net Factor Income from Abroad = 9. Private Income (--) Corporate Tax (--) Saving of Corporation (--) Retained Earnings of Foreign Companies

= 10. Personal Incomes (--) Direct Taxes (--) Miscellaneous Receipts of Government Administration = 11. Disposable Income = Consumption + Saving Measurement of National Income There are three methods of measuring National Income 1. Census of Production Method 2. Census of Income Method 3. Census of Expenditure Method

1.

Census of Production Method : This method measures the output of he country. Y=( P-D) + ( S-T) + ( X-M) + ( R-p) Y= Total income of the nation. P= Domestic output of all production sectors, D= Depreciation allowance. S= Subsidies, T= Indirect taxes X= Exports, M= Imports. R= Receipt from abroad, p= Payments made abroad. 2. Census of Income Method: In this method the income of all factors of production is added together. Y= (w + r + i + profit) + ( X-M) + ( R-p) w = wages, r = rent, i = interest 3. Census of Expenditure Method : National income on the expenditure side is equal to the value of consumption plus investment. Y= ( C + I + G) + ( X M) + ( R - P), Where, C= Consumption Expenditure, I= Investment Expenditure G= Government Expenditure.

GDP and GNP

While GDP indicates productive capacity of an economy, GNP is a crude indicator for living standard. The significance of the distinction between GNP and GDP depends on the nature of a particular economy. For instance, if a country has more non-resident inflows and produces a considerable portion of its output by multinational corporations (i.e. with the help of external factors of production), its GNP will be higher than GDP. Otherwise the distinction will be negligible. Many countries have foreign firms. In the case of US Ford Motors in Chennai, the income from the car factory would be counted as Indian GDP and not as US GDP. But the amount of profit the company sends to US will be added to their GNP. Similarly, our GNP can be arrived by adding to our GDP the net factor income receipts from abroad for the factor inputs owned by Indians. That is, the non-resident Indians income will be added to GDP to arrive at our GNP.

NI at Current Prices and Constant Prices

The concepts of national income discussed above can be measured either at current price or at constant price. The measure based on current price uses the ongoing market prices to compute the value of output. It is quite possible that the current price may always be higher than real value due to many factors like taxes and inflation (or rising prices). Hence, national income arrived at current price includes such influences as inflation and taxes. With inflation as a common feature in almost all the economies, it is necessary to measure the national income after deducting any such increase in the value of any output or income. National income at constant price measures the national income after making necessary adjustment to eliminate the effect of inflation. Thus it is based on unchanged price of output. As the national income at constant price is computed based on the real worth of the purchasing power of income, it is also called as real national income or national income in real terms.

Difficulties in the Calculation of National Income

1. 2. 3. 4. Definition of Nation ( in a open economy) Choice of Goods ( only goods having money value can be taken) Choice of Method ( availability of data) Stage of Economic Activity ( production stage, consumption stage or expenditure stage) Double Counting. Transfer Payments ( pension, unemployment allowance, interest on loans etc) Illegal Income. ( Black Money) Non-Availability of Data. Non Monetized Sector. Price Level Changes. Difficulties in Underdeveloped Countries.

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7. 8. 9. 10. 11.

Importance of National Income Studies

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. Indicator of Economic Structure. Indicator of Economic Welfare. Helpful in Economic Policy. Helpful in Economic Planning Inflationary and Deflationary Gaps. Importance in International Sphere. Determination of Grants in Aid. Basis of Budgetary Policies. Importance in Defense and Development Basis of Social Accounting Importance in Economic Analysis-growth of the economy, the trends in various sectors, the trends of various macro variables ( saving, investment, inflation, forex reserves etc.)

Circular Flow Model

Injections, withdrawals and equilibrium

The circular flow of income

Consumption of domestically produced goods and services (Cd)

The circular flow of income

Factor payments

Consumption of domestically produced goods and services (Cd)

The circular flow of income

Factor payments

Consumption of domestically produced goods and services (Cd)

BANKS, etc

Net saving (S)

The circular flow of income

Investment (I)

Factor payments

Consumption of domestically produced goods and services (Cd)

BANKS, etc

Net saving (S)

The circular flow of income

Investment (I)

Factor payments

Consumption of domestically produced goods and services (Cd)

BANKS, etc

GOV.

Net Net taxes (T) saving (S)

The circular flow of income

Investment (I)

Factor payments

Consumption of domestically produced goods and services (Cd)

Government expenditure (G) BANKS, etc GOV.

Net Net taxes (T) saving (S)

The circular flow of income

Investment (I)

Factor payments

Consumption of domestically produced goods and services (Cd)

Government expenditure (G) BANKS, etc GOV. ABROAD

Net saving (S)

Import Net expenditure (M) taxes (T)

The circular flow of income

Export expenditure (X) Investment (I) Government expenditure (G) BANKS, etc GOV. ABROAD

Factor payments

Consumption of domestically produced goods and services (Cd)

Net saving (S)

Import Net expenditure (M) taxes (T)

The circular flow of income

Export expenditure (X) Investment (I) Government expenditure (G) BANKS, etc GOV. ABROAD

Factor payments

Consumption of domestically produced goods and services (Cd)

Net saving (S)

Import Net expenditure (M) taxes (T)

WITHDRAWALS

The circular flow of income

INJECTIONS
Export expenditure (X) Investment (I) Government expenditure (G) BANKS, etc GOV. ABROAD

Factor payments

Consumption of domestically produced goods and services (Cd)

Net saving (S)

Import Net expenditure (M) taxes (T)

WITHDRAWALS

Economic Base Model Collapses All Spending into Regional and Non-Regional

INJECTION
Export expenditure (X)

Factor payments

Regional Purchases of regionally produced goods and services

OUTSIDE OF REGION

Import expenditure (M)

WITHDRAWAL