Introduction to Macroeconomics

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• Human wants are unlimited while the resources are scarce. • Economic theory or analysis deals with the basic proposition of how

human beings or individual economic units behave against the problems of scarcity and react to the observed changes.

• Human beings often face problems of scarcity and choice• The aspect of choice occurs as consumers can satisfy only some of

their wants while they have to forgo others. • The freedom of choice gives rise to opportunity cost, which is the

next best alternative choice that has been forgone. • Opportunity cost is the real cost of a choice and can be applied not

only to consumer choices at the micro level but also community choices at the macro level.

Economic analysis

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• Major focus of economic analysis is on how individual economic units have to make a choice among the limited resources.

• Economic analysis establishes reference points that indicate what to look for and how economic issues are interrelated. This enables better understanding of relationships among complex and often unrelated economic events in the actual world.

• However, a serious limitation may emanate from the assumptions, which form the basis of these propositions. Therefore such assumptions must be realistic so as to serve the purpose of understanding economic issues and propositions

Economic analysis

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Session Outline

• Classification of economics• Development of macroeconomics• Basic concepts of macroeconomics• Policy instruments• Diagnosing health of the economy• Circular flow of income

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Classification of Economics

• Positive and Normative Economics• Macroeconomics • Microeconomics

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• Microeconomics deals with the behavior of individual entities like individuals, markets, firms, households, etc.

• Thus it looks into the micro aspects of the economy, whereas macro economics studies the broader aspects of the economy and studies the behavior of an economy as a whole.

Development of Macroeconomics

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Development of Macroeconomics

• Keynes pioneered a new approach to macroeconomics and macroeconomic policy.

• Any discussion on macroeconomics starts with J M Keynes, the famous economist.

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• Prior to Keynes, the business cycles were considered to be inevitable, and there was no concrete approach to solve these problems. These economists known as Classical economists focused only on the micro aspects of the economy. The Great Depression of 1930s left many of these economists helpless.

• In this backdrop, Keynes came up with a new approach to look at the economy. In his book, 'The General Theory of Employment, Interests and Money'.

Development of Macroeconomics

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• Keynes argued that it is possible that high unemployment and underutilization of the capacities may take place and continue in the market economy. He also argued that government can play a bigger role during the economic depressions by effective utilization of monetary and fiscal policies.

• After the World War II, the focus of economics was just aimed at countering unemployment and inflation, and some economists proposed a fixed money growth rate to address these issues like inflation and unemployment. Hence these economists were called as monetarists as they have given importance to money.

Development of Macroeconomics

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Development of Macroeconomics

• In the last few decades, another school of thought has gained prominence among noted economists. These economists opine that people should be given enough incentives for their earnings, rather than imposing taxes on their earnings. This group of economists advocates incentives for savings, known as supply side economists.

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The Goals of Macroeconomic Policy

• Full employment• High living standards• Price stability• Reduction of economic inequality• Rapid economic growth• Steady foreign exchange position

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Full employment

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Full employment• The effect of this macroeconomic indicator is

directly felt by the individuals. It is imperative on any government that it should ensure full employment to the citizens of its country. Unemployment rate shows different patterns in different phases of business cycles. In the given figure , it can be seen that unemployment rate in the US was too high between 1930 and 1940. During this period, the economy witnessed one of the worst depressions.

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High level of output (GDP) • The ultimate aim of any economy is to provide the desired

goods and services. The economy should be in a position to offer these goods and services in ample number. To measure the output of any economy, Gross Domestic Product (GDP) is the most comprehensive estimate. GDP measures the market value of the entire output in a country during a particular year.

• There are two variants in GDP- Nominal and Real. When nominal GDP is adjusted for inflation, it gives real GDP.

• The importance of GDP can be analyzed by the fact that any predictions regarding the future growth or fall in the economy or date on the past economic performances are made in the GDP percentage. In the recent figures released by the Central Statistical Organization, India’s economy grew by 9.4%, in the second quarter of 2007.

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Price Stability• Stable prices are the third macroeconomic

objective. Consumer price index (CPI) is the most commonly used measure of overall price level in an economy. CPI is the measure of the cost of different types of goods bought by the average customer. Inflation denotes the rise or fall in general price level in the economy. Inflation rates, shows the rate of change in the price index. When the inflation is high, the purchasing power of the customers reduces.

• A negative fall in the prices is known as deflation, as witnessed during the Great Depression of 1930s. Whereas, hyperinflation refers to the rise in prices by thousands of percentage points, resulting in the collapse of the price systems. Hyperinflation was witnessed in Weimer Germany in the 1920s and again in Brazil in 1980s and Russia in 1990s.

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 Basic Concepts in Macroeconomics • In macroeconomics study, various

variables are used. Some are stock variables and some are flow variables. Variables like money supply, CPI, Foreign exchange reserves, which can be measured at any given point of time are called as stock variable. Whereas variables like GDP, inflation, imports, consumption and investment, which can be measured only over a period of time, are flow variables.

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 Basic Concepts in Macroeconomics • Equilibrium reflects balance between the opposing

forces, whereas disequilibrium reflects lack of such balance.

• In economic parlance, equilibrium does not mean a motionless state; rather, here the action is more repetitive in nature.

• Economic models consist of stock and flow variables. These can be either in the state of equilibrium or disequilibrium at a given point of time.

• Models that do not consider the behavior of variables from one time period to another in an explicit manner are called ‘static’ models.

• Dynamic models consider the movements of variables over different time periods in an explicit manner.

Output and income• National output is the total amount of everything a country produces in a

given period of time. Everything that is produced and sold generates an equal amount of income. Therefore, output and income are usually considered equivalent and the two terms are often used interchangeably. Output can be measured as total income, or it can be viewed from the production side and measured as the total value of final goods and services or the sum of all value added in the economy.

• Macroeconomic output is usually measured by gross domestic product (GDP) or one of the other national accounts. Economists interested in long-run increases in output study economic growth. Advances in technology, accumulation of machinery and other capital, and better education and human capital all lead to increased economic output over time. However, output does not always increase consistently. Business cycles can cause short-term drops in output called recessions. Economists look for macroeconomic policies that prevent economies from slipping into recessions and that lead to faster long-term growth.

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Unemployment

• The amount of unemployment in an economy is measured by the unemployment rate, i.e. the percentage of workers without jobs in the labor force. The unemployment rate in the labor force only includes workers actively looking for jobs. People who are retired, pursuing education, or discouraged from seeking work by a lack of job prospects are excluded.

• Unemployment can be generally broken down into several types that are related to different causes.

• Classical unemployment theory suggests that unemployment occurs when wages are too high for employers to be willing to hire more workers.

• Consistent with classical unemployment theory, frictional unemployment occurs when appropriate job vacancies exist for a worker, but the length of time needed to search for and find the job leads to a period of unemployment.

• Structural Unemployment covers a variety of possible causes of unemployment including a mismatch between workers' skills and the skills required for open jobs.

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Inflation and deflation• A general price increase across the entire economy is called inflation. When prices

decrease, there is deflation. Economists measure these changes in prices with price indexes. Inflation can occur when an economy becomes overheated and grows too quickly. Similarly, a declining economy can lead to deflation.

• Central bankers, who manage a country's money supply, try to avoid changes in price level by using monetary policy. Raising interest rates or reducing the supply of money in an economy will reduce inflation. Inflation can lead to increased uncertainty and other negative consequences. Deflation can lower economic output. Central bankers try to stabilize prices to protect economies from the negative consequences of price changes.

• Changes in price level may be the result of several factors. The quantity theory of money holds that changes in price level are directly related to changes in the money supply. Most economists believe that this relationship explains long-run changes in the price level. Short-run fluctuations may also be related to monetary factors, but changes in aggregate demand and aggregate supply can also influence price level. For example, a decrease in demand due to a recession can lead to lower price levels and deflation. A negative supply shock, such as an oil crisis, lowers aggregate supply and can cause inflation.

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Macroeconomic modelsAggregate demand–aggregate supply

• The AD-AS model has become the standard textbook model for explaining the macroeconomy.

• This model shows the price level and level of real output given the equilibrium in aggregate demand and aggregate supply. The aggregate demand curve's downward slope means that more output is demanded at lower price levels.The downward slope is the result of three effects: the Pigou or real balance effect, which states that as real prices fall, real wealth increases, resulting in higher consumer demand of goods; the Keynes or interest rate effect, which states that as prices fall, the demand for money decreases, causing interest rates to decline and borrowing for investment and consumption to increase; and the net export effect, which states that as prices rise, domestic goods become comparatively more expensive to foreign consumers, leading to a decline in exports.

• In the conventional Keynesian use of the AS-AD model, the aggregate supply curve is horizontal at low levels of output and becomes inelastic near the point of potential output, which corresponds with full employment.

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• The AD–AS diagram can model a variety of macroeconomic phenomena, including inflation. Changes in the non-price level factors or determinants cause changes in aggregate demand and shifts of the entire aggregate demand (AD) curve. When demand for goods exceeds supply there is an inflationary gap where demand-pull inflation occurs and the AD curve shifts upward to a higher price level. When the economy faces higher costs, cost-push inflation occurs and the AS curve shifts upward to higher price levels. The AS–AD diagram is also widely used as a pedagogical tool to model the effects of various macroeconomic policies.

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Policy Instruments• Fiscal Policy

• Monetary Policy

• Exchange Rate Policy

• Price and Income Policy

• International Trade Policy

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Fiscal Policy

• Fiscal policy is concerned with the use of taxes and government expenditures. Government has to meet various expenditures like salaries, defense expenses, infrastructure development, etc. Another part of government expenditure also goes in the form of transfer payments like financial assistance to the elderly and unemployed. All these expenses leave a positive effect on the overall economy. The impact of government spending is also felt on the overall spending in the economy, thus influencing the size of the GDP.

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Fiscal policy• The other part of the fiscal policy is generation of

revenues for the government. Taxes are the main source of revenue for any government. Taxes affect the economy and the individuals in two ways. First, taxes imposed on the income of the people bring down the disposable income in the hands of the consumers. This reduces the spending in the economy. Second, the taxes levied on goods and services make them costlier. This discourages the firm to invest in capital goods.

Case Study• In late 2012, the U.S. was in the midst of an extended period of intense political

partisanship. Congress was in a stalemate on nearly every issue. In particular, fiscal policy came to a standstill. By the end of the year, it became clear that Congress would be unable to agree on a budget. Congress had previously mandated in 2011 that if a deal were unable to be reached, certain automatic budget cuts and tax increases would be enacted on January 1, 2013. As it became known, the “fiscal cliff,” included the expiration of the Bush tax cuts, the expiration of the payroll tax holiday, and spending cuts across most federal agencies. Amidst a fragile economic recovery,such sudden and substantial fiscal contraction would certainly have a significant impact on economic growth. Clients were deeply concerned about whether the U.S. would indeed “go over the fiscal cliff”, and if so, what it would mean for the U.S. economy.

• The advice on fiscal policy issues helped elucidate Washington politics and fiscal policy outcomes for

• clients, which in tu• rn helped them make more informed and strategic business decisions.

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Monetary Policy• Monetary policy is the second most widely

used macroeconomic policy instrument. Monetary policy helps government, managing the nation’s money, credit, and banking system. There are various entities that are part of the monetary system of an economy. Central bank regulates the monetary system, and other entities like banks, insurance companies, NBFCs are also a part of the monetary system.

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Monetary Policy• In India, Reserve Bank of India is the

custodian of the monetary system of the economy. Central bank brings changes in the interest rates, reserve requirements, etc. These changes make significant impact on the overall functioning of the economy. 

• For example, the lowering of interest rates on housing loans helped the growth of the housing sector. As a result of low rate of interest, it became easier to avail a housing loan and to own a house. This has resulted in the growth of many allied industries as well.

Case Study• India faced a steep inflationary pressure right from the beginning of the year

2008. In May 2008, inflation touched double digit figures and continued to move in an upward direction. The inflation was feared to choke the steady growth of the Indian economy. The Indian government took several steps to combat inflation. In July, the Reserve Bank, the central bank of India, also took action to tame the inflation as soon as it reached a thirteen year high, crossing 12.5%. RBI increased the repo rate and cash reserve ratio to indicate a tight monetary policy to be implemented. The central bank was able to withdraw a substantial amount of money through the tight monetary policy. However, this raised anguish and anger among the industrialists and businessmen in India. The tight monetary policy was viewed as a double whammy in the face of rising inflation. Some feared, that the policy would hamper business environment and affect the price sensitive sectors like manufacturing, automobiles and real estate etc. On the other hand, some economists argued that RBI's step was appropriate and quite expected. Those who are in favour of the policy believed that tight monetary policy would be an obstacle to economic growth in the short run, but would improve the growth prospects of the economy in the long-run.

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Multiplier Model

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• The Keynesian multiplier was introduced by Richard Kahn in the 1930s. It showed that any government spending brought about cycles of spending that increased employment and prosperity regardless of the form of the spending.

• The multiplier effect refers to the increase in final income arising from any new injection of spending. The size of the multiplier depends upon household's marginal decisions to spend, called the marginal propensity to consume (mpc), or to save, called the marginal propensity to save (mps).

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• Every time there is an injection of new demand into the circular flow there is likely to be a multiplier effect. This is because an injection of extra income leads to more spending, which creates more income, and so on. The multiplier effect refers to the increase in final income arising from any new injection of spending.

• The size of the multiplier depends upon household’s marginal decisions to spend, called the marginal propensity to consume (mpc), or to save, called the marginal propensity to save (mps). It is important to remember that when income is spent, this spending becomes someone else’s income, and so on. Marginal propensities show the proportion of extra income allocated to particular activities, such as investment spending by UK firms, saving by households, and spending on imports from abroad. For example, if 80% of all new income in a given period of time is spent on UK products, the marginal propensity to consume would be 80/100, which is 0.8.

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The following general formula to calculate the multiplier uses marginal propensities, as follows:1/1-mpcHence, if consumers spend 0.8 and save 0.2 of every £1 of extra income, the multiplier will be:                1/1-0.8

                = 1/0.2

                = 5Hence, the multiplier is 5, which means that every £1 of new income generates £5 of extra income.

Case StudyMedical Tourism is an upcoming industry and has got vast potential, but out of total India has got 8% of the market share which is too meagre. So there is a need to plan short term and long term strategy at the regional level and at the national level, to make India the destination for Medical Value tourism. as per the international standards, Indian doctors being the best considering 38% doctors in U.S. and 23% in U.K being Indian .patient centric care, treatment being made as complete experience, focus on less system error and Joint Commission International (JCI ) accreditation becoming order of the day along with other support facilities. However in order to leverage the vast future potential, we have a long way to go. There is a need to focus on getting great facilities, combining medical with tourism. Making India being perceived as the destination and bridge the biggest barrier in the form of infrastructure and super specialty hospitals and encourage investments in healthcare sectorsAs most of us are aware, good health is a prerequisite for human development and this has led to the growing emphasis among the general public on the importance of healthcare. Patients are now seeking for higher quality healthcare services and standards, more affordable medical treatment as well as shorter waiting times. To fulfill these expectations, patients are willing to travel across the world to receive treatments that can give them “value for money”. The process of “leaving home” for treatments abroad is an emerging phenomenon in the healthcare services industry that has the potential to generate multiplier effects on the economy.

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