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.

Economic analysis

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• 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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Sustainable Balance of Payments• Globalization has resulted in increased transactions

between a country and the rest of the world. Balance of Payments records all these transactions, both imports and exports. Countries keep a close watch on their international trade.

• The barometer that shows the efficiency of international trade is the net exports. It is the difference between the value of exports and value of imports. Net exports are also called as the balance of trade.

• Every country desires to have a positive balance of trade.

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Economic growth

• Every country wishes to and strives for having a constant growth in its economy. There are two parameters that judge the rate of growth that an economy achieves. Increase in production possibility curve or

schedule Growth in GDP or per capita income

• If GDP is growing at g% per annum and population at p%, per capita GDP must be growing by= (1+g / (1+p) - 1

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Basic Concepts

• Stocks and Flows

• Equilibrium and Disequilibrium

• Statics and Dynamics

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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.

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Diagnosing Health of the Economy

• National Product and Domestic Product• Aggregate Consumption• Gross Domestic Savings• Gross Domestic Capital Formation• Wholesale Prices, Consumer Prices and

Inflation• Employment• Balance of Payments• Rate of Growth

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Policy Instruments

• Fiscal Policy

• Monetary 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.

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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.

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Exchange Rate Policy

• Exchange rates are determined by the demand and supply functions.

• India follows a flexible exchange rate policy, which is determined by the demand and supply, where RBI has a right to intervene in the market. In order to regulate the foreign exchange transactions, government has come out with an act FERA, which was replaced by Foreign exchange management act (FEMA).

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Employment Policy• Employment policies are adopted by

government in order to increase the employment level in the country. As a part of this policy, governments come out with various polices. For example, in India, government has

introduced various policies and schemes like, Jawahar Rozgar Yojna etc.

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Price and Incomes Policy

• This policy aims at regulating the prices in the market and also to ensure the minimum wages to the workers.

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International Trade Policy• Globalization has given a big push to the international

trade. This has resulted in framing of specific polices by many countries to cope with the new challenges. International trade policy addresses issues like tariff and non tariff barriers.

• In line with the changing economic scenario, government came out with export-import (EXIM) policy in 1997. The policy’s primary aim is to increase the exports. It has been renamed as foreign trade policy to reflect the new approach.

• Example: The recent policy announced in January 2006 has taken up a series of policy initiatives to fine tune the policy 2002-07. The policy aims at bringing down the transaction costs, accelerating the exports and making the country a manufacturing hub for quality goods and services. SEZs to promote not only manufactured goods but also agricultural products. Special emphasis is placed on exploiting Indian Labour skills to further exports.

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The Circular Flow of Income

• Two Sector Economy

• Closed Economy

• Open Economy

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Two-Sector Economy(When All Income is Consumed)

Household Sector

Private Consumption (C) Rs.1000

Productive Sector

Wages and Profits (i.e. income (Y)Rs.1000

CY

CAD

ADY

iumAtEquilibr

:

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Closed Economy

Household Sector

Private Consumption (C) Rs.800

Productive Sector

Wages and Profits (i.e. income (Y) Rs.1000

Savings (S) Rs.200

Investment Rs.200

IS

iumInEquilibr

ICSCAD

ADY

iumAtEquilibr

:

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Open Economy

Household Sector

Private Consumption (C) Rs.800

Productive Sector

Wages and Profits (i.e. income (Y) Rs.1000

Savings (S) Rs.100Imports (M) Rs.50Taxes (T) Rs.50

[Withdrawals (W) Rs.200]

Investment (I) Rs.80Exports (E) Rs.60Government Expenditure (G) Rs.60

[Injections (J) Rs.200]

JC

XGICY

ADY

iumAtEquilibr

: