Em PA Knowledge With | ! 3 Success Scanned with CamScanner) ZY, 1 v ey An Overview Macro Economics Analy Basic Concepts National Income and Related Aggregates Circular Flow of Income National Income Measurement Theory of Employment and Income Goods Market Money Market-I: Money and Money Supply Money Market-II: Demand For Money Integration of Goods and Money Market ‘Two Sector IS-LM Model Aggregate Demand Aggregate Supply Model Investment Spending Inflation and Unemployment Inflation and Money Py COOD.KALIANLN a on ten ts 2 Chapters Page No. 01-09 10-23 24-37 38-49 50-67 68-88 89-113 114-128 129-142 143-161 162-178 179-189 190-210 211-224 Lm YY, Sy Hy WOEPIRADN SH Y 11. ~X ae “OD Scanned with CamScannerMACRO ECONOMIC ANALAYSIS : AN OVERVIEW 1. 1 Introduction : The term ‘Economics’ in English language has been derived from two Greek words— Oikos (Houschold) and Nomos (to manage). Thus, the word economics used to mean home management with limited funds available in the most possible economical manner. The economics was born with the publication of Adam Smith’s book “An Inquiry into the nature and causes of Wealth of Nations”, in the year 1776. At its birth, the name of economics was ‘Political Economy”. The term “political in the phrase “political economy” seemed an embarrasment. So it was droped, and the ending “ICS” as in Physics, was tacked onto the end of “econom”, to make it sound more scientific. And that is what the new field ‘was called-‘Economics” Economics is a social science which seeks to explain the economic basis of human society. Economics is broadly divided into two branches-Microeconomics and Macro-economics. The term ‘MACROECONOMICS? was coined by Nobel Laureate Ragnar Frisch in 1933. Emergence of Macro economics Macroeconomics, as a separate branch of economics, emerged after the British economist John Maynard Keynes published his celebrated book, “The General Theory of Employment, Interest and Money” in 1936. The dominant thinking in economics before Keynes was that all ‘employable resources-labour and capital of'a country are always fully employed in the long term. This school of thought is known as the “Income Theory”. However, the Great Depression of 1929 and the subsequent years saw the output and empioyment levels in the countries of Europe and North America fall by huge amounts. It affected other countries of the world, as well demand for goods in the market was low, many factories were lying idle, workers were thrown out of jobs. In USA, from 1929 to 1933, unemployment rate rose from 3% to 25% (unemployment rate may be defined at the number of people who are not working and are looking for jobs divided by the total number of people who are working or looking for jobs). Over the same period aggregate output in USA fall by about 33%. These events made economists think about the functioning of the economy in a new way. The fact that the economy may have long lasting unemployment had to be theorised about and explained Keynes” book was an attempt in this direction. Unlike his predecessors, his approach was to examine the working of the economy in its entirely and examine the interdependence of the different sectors. The subject of MACRO ECONOMICS was born. 1.2 Meaning : ‘The term macro comes from the Greek word “Macros” which means large. Thus, macroeconomics is concerned with the behaviour of the economy as a whole. RGD. Allen, States that The term macroeconomics is applied to the study of relation between broad economic aggregates. According to Boulding Macroeconomics is that part of economics when studies the overall averages and aggregates of the system. In the words of Gardner Ackley Macroeconomics concerns itself with such variables as the aggregate volume of ‘output of an economy, with the extent to which its resources are employed with the size of national income, with the general price level. Scanned with CamScanner& , $ 2 | Macro Economics It is obvious that in macro or aggregative analysis we concentrate upon the magnitude of the variables rather than its composition or structure. To illustrate, Gardner Ackley points out that we are interested here in the overall dimensions of econ: omic life jn, the same manner as we look at an elephant in its total dimension and not in its compo or the working or articulation of the component parts. Just as we look at the forest asa huge Cluster and hot as constituted by the individual trees or we look at the pond of water in its entirely rather than its being constituted of very small molecules of water, the aggrcgative approach in the same way looks at the economic system in its entirety and not in smal] fragments. Hanson has interpreted macro-economics as “that branch of economics which considers the relationship between large aggregates such as the volume employment, total amountof saving and investment, the national income etc.” This indicates that the scope of our analysis is not simply restricted to the investigation of the total magnitudes of the economic variables but their interrelations too are an essential part of the macro economic analysis, I is not enough to know the total magnitudes of the national income, national product, aggregate expenditure, aggregate demand, aggegate supply, total employment, general Price level, aggregate saving and aggregate investment. Macro-economic analysis, on the other hand, must devote itself to such questions as how the changes in national income affect the general business activity, how the price level is influenced by an increase in aggregate volume of employment and in what way the changes in ageregate saving and investment affect the level of national income. Meyer has also explained the ageregative or “Macro economics in a similar way. He states that “Macro economics is the study of the nature, relationship and behaviour of aggregates and average of economic quantities. 1.3 Subject Matter Of Macroeconomics There is no clear-cut division between micro- and macro-economics. The scope of macroeconomics ean be stated by giving a list of the most important problems with which it is concerned. As noted before, macroeconomics is concerned with the behaviour of the economy as a whole. The subject matter of macroeconomics is income and employment, inflation, balance of payment problems etc. which occur in milder forms all the time. The purpose of macroeconomics is to present a logical framework for the analysis of these phenomena. What docs determine income and employment ? What does determine the price level ? How are these related ? What policies can be used to affect them and how do they work ? These are some of the questions the analytical framework presented here is ment to handle. Real income, employment, the price level and the balance of payments are determined by the interaction of decisions made by individuals when solving their economic problems, decisions about the consumption and investment, decisions about the allocation of wealth among alternative assets, decisions about how much labour to hire and supply, and many others. Though these decisions are interdependent, it is useful to subdivide the economy into various sectors of decision- making in order to examine what forces operate in each sector before looking at the interdependence among them. 1.4 Major Issues in Macro Economics Or Scope Of Macro Economics | ‘Macro Economics gained great prominence after the publication of Keynes” monumental work ‘ The General Theory.’ The scope of macro economics continued to get more and more widened in the subsequent decades. It is explained below: @ Measurement of National Income : The study of national income and social accounting is a very prominent development since the beginning of Keynesian revolution. In the entire Post-Keynesian economic literature, national income becamt the pivotal aggregative variable. The social accounting and the input-outpul techniques of measuring national income are based respectively on the aggregation Scanned with CamScanner| | ap Macro Economic Analysis : An Overview | 3 of sector accounts and that of inter-industry variables. It was only under the compulsions of handling the most accurate estimate of the national income aggregate that such techniques could possibly be evolved. Inflation and deflation : The problems of inflation and deflation, which have continually plagued the economic life of the pcople throughout the world, are analysed on the basis of agercgative variables. Inflation manifests itself in a rise in general level of prices. This phenomenon is contingent upon the aggregative variables like consumption expenditure, investment and the general level of production. The measurement of inflationary or deflationary gaps is also made through the difference in the magnitude of saving and investment in the community. If we ignore these macro economic variables and still try to determine the extent of inflationary or deflationary gap, it will just be an exercise in futility leading only to fallacious conclusions. The aggregative approach again helps in devising such ways and means which may mitigate the inflationary and deflationary strains off the economy in the most decisive way. (iii) Business cycle theories : The biggest malady associated with the capitalist @ ” wo (iit) economies is the business oscillations. Almost all the theories concerning trade cycles formulated even earlier than Great Depression of 1930's were based on aggregative or sub-aggregative variables. In the recently developed trade cycle models based upon a complex of exogenous, endogeneaus and structural parameters, the macro approach is all pervading Problems of poverty and growth : The problems of poverty and growth can be investigated in any worth while manner only from an aggregative viewpoint. The economic, demographic, technical, social and cultural forces and intricate complexes of the numerous variables conjure before us a realistic picture of the poverty or backwardness of a nation. The entire empirical and operational research, as a matter of fact, has been carried through aggregative instruments. Various growth models, involving variables like saving and investment co-efficients are obviously the outcome of aggregative approach. All the measures adopted with the purpose ofraising the standard of living or ensuring the optimal level of production must, of necessity, be based upon the aggregative thinking otherwise their effectiveness will certainly be out of the question. Economic policies : The macro analysis is significant in the formulation of economic policies. As a consequence of Keynesian revolution, the laissez- faire philosophy stands thoroughly exploded and the governments have assumed the most crucial and dynamic role of reinforcing the economic system. The economic policies for the removal of poverty, unemployment and for ensuring stabilization must necessarily be based upon the aggregative requirements. Any economic policy prompted by the considerations of small individual units will be clearly irrational, muddle-headed and short-sighted and will certainly lead to baffling consequences. Employment and Unemployment : Unemployment refers to involuntary idleness of resources including manpower. If this problem exists, society's actual output will be less than its potential output. So one of the objective of Government policy is to ensure full employment which implies absence of involuntary unemployment of any type. Stagflation : Most modem mixed economies suffer from the disease of stagflation which implies the co-existence of inflation and unemployment in a stagnant economy. The trade off between inflation and unemployment is perhaps the most complex macro-economic issue of the day. Every country in the world is now struggling hard to fight the disease of stagflation. ETT Scanned with CamScanner4 | Macro Economics + (ily The Exchange rate and the Balance of payments : The Balance of paymes > systematic record ofall economic transactions between the members of trent 8 SYuntry and the rest of the world in an accounting year. These transact 20m, largely, it not entirely, influenced by the exchange rate. ‘ONS ary lawned It is the rate at which a country’s economy is exchanged for another curreney (or It can be explained in two ways 1 § can buy Z 48 Or & I can buy § 1/48. Bold), Exchange rate is % 48/S. | 1 Or ag8/® Both the ways of expressing the exchange rate are equivalent. IfExchange rate decreases from ¥ 48/S to¥ 45 /S Then it is called depreciation of, ‘Arise in exchange rate is called an appreciation. When the domestic currency depreciates it buys less of the foreign currency and whey it appreciates it buys more. 1.5 Limitations of Macro-Economics | ‘An excessive pre-occupation with macro approach poses serious difficulties for the practical application of its tools. But the analytical significance of this approach is beyond any doubt. It suffers from certain limitations at right but they do not invalidate the macro. economic technique itself. Almost all of these limitations flow from the tendency of treating aggregates as constituted by the individual micro fragments. @_ Generalisation from individual experience : The main limitation of the aggregative approach is that the logic and conclusion which may be true for the individuals or small units tend to be applied to the large aggregates. The generalisations derived | from individuals and applied to the whole may be dangerous, irrelevant and misleading. From the point of view of an individual, the accumulation of saving may be considered as desirable but any attempt towards collective saving by the entire community can land it into depression. In the same way, an individual's withdrawal of funds from the bank may be regarded as quite normal and necessary but the withdrawal of funds by all the depositors at the same time causes a serious banking crisis and threatens the collapse of banks, Boulding has very aptly remarked that “we must be on our guard against generalising from our individual experience, just because we ourselves can do somethings is no reason for supposing that ‘everybody can do it at the same time. Gi) Too much concentration on aggregates : Another difficulty or danger associated with macro-economic analysis is that there is an excessive thinking concentrated upon the aggregates which may be made up of non- homogeneous constitutes. Thus most of the attention is paid to the aggregates that may be quite meaningless or analytically inconsequential. Boulding has referred to certain aggregates which are entirely different in their structure and, therefore, have varying analytical and practical significance. He states that a combination of 2 apples + 3 apples = 5 | apples is a meaningful aggregate. 2 apples + 3 oranges = 5 fruit may be regarded as a fairly meaningful combination. In this case, the internal structure of aggregate is undoubtedly non-homogencous never the less the commodities can be grouped together as fruit and the combination is meaningful up to a degree. But there is no common denominator in a combination constituted by 2 apples + 3 sky scrapers and as such this aggregate, by no stretch of imagination, can be regarded as meaningful. Thus it is clear that a preponderant thinking about the aggregates results in over looking their internal composition and structure. ) Difficulties in measuring aggregates: As indicated above the aggregate may often be composed of heterogenous elements which in addition to being | meaningless are quite difficult to be handled for the purposes of analysis and | SLL ETN SAGAR ~ Scanned with CamScannerMacro Economic Analysis : An Overview | 5 formulation of economic policies various heterogenous quantities, it is asserted, can be expressed in terms ofa common denominator of money and can, therefore, be conveniently aggregated. But the difficulty with moncy is that its value continiously changes. The aggregates of monetary values of all the items thus become immeasurable and non- comparable and such an aggregation becomes quite absurd. Gv) Neglect of internal differences of aggregates : Macro-economic approach is deficient also because it has a tendency to overlook the differences within the aggregates. During a specific period the level of aggregate output in a country might have remained stable, but it is likely that the proportion of luxury goods to other commodities in the total output might have increased. The general price level ina country, over a certain period, might have gone up but the prices of industrial products might have gone down by a noticeable margin. Similarly, it may be possible that the national income in a country has gone up but the entrepreneurial class has become for better off than the wage-earners. An analysis of the aggregates, without taking into account the glaring differences which may exist within the aggregate, is incomplete and grossly defective. @ Baffling diversities : The aggregates which compose a system may not be analytically or practically significant or important. The general price level in a country, for instance, is composed of all types of prices including the wholesale and retail prices. In addition to product prices, it is also significantly influenced by the factor-service prices like wages, rents, interests and profits and the prices of bonds, securities, mortgages etc. Some of these prices may move in one direction while the others may move in the opposite direction. The variation in some other category of prices may be quite erratic. There may also be significant difference in the rates of price variations in respect of different price categories..An aggregate based on so numerous diversities is absolutely unintelligible and cannot be distinguished from a hotch- potch or utter confusion. It is evident from the above discussion that the limitations associated with macro- economics affect only its practical significance. There is no way to disprove the validity of the aggregative thinking. 1.6 Micro Foundation of Macro Economics The analytical apparatuses employed in the micro and macro economics are, undoubtedly, of quite diverse and independent nature. They make use of different methods and instruments in the field of theoritical investigation and economic policies. It is also true that the summing up of multitudes of micro units leads to the problems of aggregation and fallacy of composition. Still some economists including sargent and Wallace laid stress upon this aspect that despite the clear difference between the two approaches, it could not be denied that the aggregative economics faild to abandon some basic assumptions of the micro economics. The macro economics, in fact, continues to have some micro economic foundations. It is discussed as under @ Rationality of Consumer : A basic assumption of micro economics is that the consumer is rational. He spends his income in such a way that he derives maximum satisfaction. In macro economics, the basic assumption of consumer’s rationality has not been given up even when investigation is related to the satisfaction or welfare of the whole society or community. Gi) Rationality of Producer : Micro economics treates producer also as rational. It is supposed that he employs such a combination of factor inputs that can maximise his profits or sales. Macro economics too fully recognises the validity of such an assumption about the behaviour of producers. ETS Scanned with CamScanner