POME-Chapter-1 (2) (5 Files Merged)

1 Introduction of Economics
PRINCIPLES OF
MACROECONOMICS
N. G R E G O R Y M A N K I W
PowerPoint® Slides
by Ron Cronovich
© 2007 Thomson South-Western, all rights reserved

In this chapter, we will be able to know-
Topics covered
1.1 Introduction of Economics
1.2 Definition of Economics
1.3 Branches of Economics
1.4 Differences - Microeconomics and Macroeconomics
1.5 Central Problems of an Economy
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 1

Introduction of Economics
 Economics is about economizing; that is, about
choice among alternative uses of scarce
resources.
 Choices are made by millions of individuals,
businesses, and government units.
 Economics examines how these choices add up
to an economic system, and how this system
operates.
2
 Scarcity is central to economic theory.

 Economic analysis is fundamentally about the
maximization of something (leisure time, wealth,
health, happiness—all commonly reduced to the
concept of utility) subject to constraints.
 These constraints—or scarcity—inevitably define
a tradeoff.
3
 For example, one can have more money by

working harder, but less time (there are only so
many hours in a day, so time is scarce).
 One can have more apples only at the expense
of, say, fewer grapes (you only have so much
land on which to grow food—land is scarce).

 The word ‘Economics’ was derived from the

Greek words ‘Oikos’ (a household) and ‘Nemein’
(to manage), which meant managing a
household, using the limited money or resources
a household has.

DEFINITIONS OF ECONOMICS
Wealth Definition – Adam Smith
 Adam Smith, who is also regarded as father of
economics, stated that economics is a science
concerned with the nature and causes of wealth of
nations.
 That is, economics deal with the question as to how to
acquire more and more wealth by a nation.
6
Welfare Definition - Marshall
 Economics not only analysis the aspect of how to
acquire wealth but also how to utilize this wealth for
obtaining material gains of human life.
 Wealth is a means to achieve certain ends.
 Economics is not a science of wealth but a science of
man primarily. It may be called as the science which
studies human welfare.

Welfare Definition - Marshall
 Economics not only analysis the aspect of how to
acquire wealth but also how to utilize this wealth for
obtaining material gains of human life.
 Wealth is a means to achieve certain ends.
 Economics is not a science of wealth but a science of
man primarily. It may be called as the science which
studies human welfare.
8
 Lionel Robbins challenged the traditional view of the
nature of economic science.
 He called all the earlier definitions as classificatory and

unscientific.
 According to him, “Economics is the science which

studies human behaviour as a relationship between ends
and scarce means which have alternative uses.”

BRANCHES OF ECONOMICS
 The subject matter of economics is divided into

two categories
• Microeconomics
and
• Macroeconomics.
10
1. Micro Economics
 In Greek mickros means small.
 Microeconomics deals with a small part of the whole economy.
 It is the study of the economic behaviour of individual consumers,
firms, and industries and the distribution of production and income
among them.
 It considers individuals both as suppliers of labour and capital and as
the ultimate consumers of the final product.
 On the other hand, it analyses firms both as suppliers of products and
as consumers of labour and capital.
11
2. Macro Economics
 In Greek mackros means large.
 Macroeconomics deals with
• the aggregates of the system.
• with the behaviour of various economic variables that refer to the
economy as a whole.
 These variables are—total national income, aggregate employment,
the extent to which the economy’s resources are being fully employed,
aggregate saving and investment, and the general price level in the
economy.
 Thus, under macroeconomics we study economy as a whole.
12
DISTINCTION BETWEEN MICROECONOMICS AND
MACROECONOMICS

CENTRAL PROBLEMS OF AN
ECONOMY/SOCIETY
 The
economic
problems of
an economy
are
unlimited
wants and
limited
resources.
14
CENTRAL PROBLEMS OF AN ECONOMY/SOCIETY
 1. What goods and services are to be produced?

• Consumer goods or Capital/producer goods
 2. How to produce these goods and services?

• Labour Intensive Method and Capital-Intensive Method
 3. For whom these goods and services are to be

produced?
• Paying Capacity – Rich or Poor
 4. Are the resources efficiently used?

 5. Are the resources fully employed?
 6. How to attain growth in the economy?
16
CHAPTER 1 Introduction of Economics
REVIEW QUESTIONS
 Define economics.
 Explain various definitions of economics.
 What are the economic problems that every
economy has to face? Discuss in detail.
 Distinguishbetween microeconomics and
macroeconomics.
18
REFERENCES
 https://ebookcentral.proquest.com/lib/shctom/det
ail.action?docID=346118&query=macro+econo
mics
mics

CIRCULAR FLOW AND NATIONAL INCOME
2 MEASUREMENT
PRINCIPLES OF
MACROECONOMICS
PowerPoint® Slides
by Ron Cronovich

 Topics covered:
 Introduction
 The Circular Flow of Income
 National Income Measurement
 Concepts of National Income
 Methods of Measuring National Income
 Problems in Calculation of National Income
 Nominal GDP
 Real GDP
1
Introduction
 National income, output, and expenditure are generated

by the activities of the two most vital parts of an economy,
its households and firms, as they engage in mutually
beneficial exchange.
 Households: Households are the suppliers of factors of

production (land, labour, capital and entrepreneur) to the
firms for production of goods and services.
 Firms: firms are the suppliers of goods and services to
households, firms in the country and abroad.
2
THE CIRCULAR FLOW OF INCOME
 Income (Y) in an economy flows from one part to another
whenever a transaction takes place.
 New spending (C) generates new income (Y), which

generates further new spending (C), and further new
income (Y), and so on.
 Thus the spending and income keep on circulating around

the economy. This is called circular flow of income.
3
Circular flow of income can be explained through
different models:
1. Simple Economy Model

2. Open Economy Model
4
1. Simple Economy Model
Simple Economy Model (Two Sectors Model)

 There are only two sectors in the economy namely
households and firms.
 There is no government, no financial markets, and no
imports or exports.
 We imagine that the households spend all their incomes
on goods and services and the firms would sell all the
produced goods to consumers.
5
1. Simple Economy Model
 Circular Flow of Income in Two Sector Economy
Here we have two markets in this circular

 Market for goods and services
 Markets for factors of production.
6
1. Simple Economy Model
 Kinds of flows:
 The real flow: It is from households to firms in the form of factors of
production (labour, capital, land). Another real flow is from firms to
households which are goods and services.
 Money flows: Money flows from firms to households in terms of
Wages, Rent and Profit, and another is flow of money from
households to firms in terms of consumption, payment to the firms for
goods and services.
 The Payment made by firms to household for factors of production is
known as income. So the National income is the total income of all
households.
 In this simple model, the households spend all their incomes for
buying goods and services, it is called expenditure.
7
2. Open Economy Model
 This model is a more realistic representation of the economy. In this
model we introduce new sectors in the economy which are :
 Government sector.
 Financial Sector (Banks)
 Foreign sector.
8
2. Open Economy Model
Role of Sectors:
 1. In this model the households do not spend all their income,
they save some part of it. This is called saving. Thus, saving is the
difference of income and consumption (S= Y-C). The households
keep this saving in their banks.
 2. The financial sector: This sector gives this saving as loans to
the business sector for investment. Thus saving flows again in the
circular. In this situation to be in equilibrium level, the saving should
be equal to investment (S = I).
 3. The government sector imposes taxes on households and
firms but in return these taxes are transferred into government
spending .In this situation to be in equilibrium level, taxes should be
equal to government spending, T = G.
9
 Role of Sectors:
 4. The foreign sector deals with the flow of money from the rest of
the world to the local firms in the form of exports (x) and flow of
money from households to the rest of the world in the form of imports
(M).
S= Saving. X=Exports
Y= Income. M=Imports
C= Consumers spending on goods and service
I= Investments
G= Government spending
T=taxes
10
 Role of Sectors:

11
NATIONAL INCOME MEASUREMENT
Introduction of National Income
 Measurement of National Income refers to the calculation

of the total output or income of a country.
 Output is defined as quantity of goods and services
produced in a country in a given period of time.
 Measurement of National Income is important as it gives a
clear picture about country’s spending, income and output
for a specific period of time.
12
Meaning of National Income
 National Income refers to total ‘national output’

or value of a nation’s output during a specific
year.
13
NATIONAL INCOME MEASUREMENT
Importance of Measuring National Income
Measuring the level and rate of growth of national income is

important due to following reasons: -
1) To know the rate of economic growth of a country.

2) To know the changes in living standard of the people.
3) To understand the changes in distribution of income
between different groups of people
14
CONCEPTS OF NATIONAL INCOME
1) Gross Domestic Product (GDP)

2) Gross National Product(GNP)
3) Net National Product (NNP)
4) Net Domestic Product (NDP)
5) Personal Income (PI)
6) Disposable Personal Income (DPI)
7) Per Capita Income (PCI)
15
1) Gross Domestic Product (GDP)

Gross Domestic Product (GDP)
 GDP is the total market value of all final goods and
services produced within the domestic boundaries of a
country in a year.
 It is the value of goods and services produced within the
boundary of a country by nationals or foreigners.
 Example: If a Japan based car producer Honda works in
Oman, the value of output will be added in GDP of Oman
16
2) Gross National Product(GNP)

Gross National Product(GNP)
 GNP is the total market value of all final goods and services produced
by the residents or citizens of a country, even if they are living in other
countries.
 In other words, it is the amount of goods and services produced by
residents of a country regardless of where that production takes place.
 Example – Oman’s GNP values is the value of output produced by
Omani citizens’ companies regardless of where the firms are located.
 GNP = GDP + Net factor income from abroad.
17
3) Net National Product (NNP)

Net National Product (NNP)
 NNP is the market value of all final goods and services
after providing for depreciation.
 That is, when charges for depreciation are deducted from
the GNP we get NNP at market price.
 Therefore’
NNP = GNP – Depreciation
 Depreciation is the consumption of fixed capital or fall in
the value of fixed capital due to wear and tear.
18
4) Net Domestic Product (NDP)
Net Domestic Product (NDP)

 Net Domestic Product can be obtained by deducting
depreciation from GDP.
 Thus,
NDP= GDP – Depreciation
19
GDP (Gross Domestic Product) Versus GNP (Gross National Product)
 GDP is the total market value of goods and services

produced within the domestic borders of a country,
regardless of the nationality of those who produce them.
 GNP is the total market value of goods and services
produced by the citizens of the country, even if they are
living abroad.
20
5) Personal Income (PI)

Personal Income (PI)
 This is the actual income received by individuals and
households in the country from all sources.
 It denotes aggregate money payments received by the
people in the form of wages, interest, profits and rents
etc.
21
6) Disposable Personal Income (DPI)
 Disposable Personal Income

 What remains after deducting tax from personal
income, is called disposable income.
Thus,
 Disposable Income = Personal income – personal taxes,
property taxes, and insurance payments
22
7) Per Capita Income (PCI)

Per Capita Income (PCI)
 Per Capita Income can be defined as average income
earned per person in a country in a specific year.
 It is obtained by dividing country’s total income by its
population.
 Thus,
PCI= Country’s total income (National Income)
Country’s population
23
METHODS OF MEASURING NATIONAL INCOME
 Production generate incomes which are again spent on

goods and services produced.
 Therefore, national income can be measured by three
methods:
1) Output or Production method
2) Income method, and
3) Expenditure method.
24
1) Output or Production Method:
Output or Production Method:

 This method is also called the value-added method.
 Under this method, the economy is divided into different
sectors such as agriculture, fishing, mining, construction,
manufacturing, trade and commerce, transport,
communication and other services.
 GDP (Y) =Agricultural sector output + industrial sector
output + service sector output
25
2) Income Method:
Income Method:
 According to this method, national income is obtained by
summing up of the incomes of all individuals in the
country.
 Thus, national income is calculated by adding up the rent of
land, wages and salaries of employees, interest on capital,
profits of entrepreneurs and income of self-employed people.
 This method of estimating national income has the great
advantage of indicating the distribution of national income
among different income groups such as landlords, capitalists,
workers, etc.
GDP (Y) = Wages + Profits + Interest + Rent
26
3) Expenditure Method:
 Expenditure Method:
 This method arrives at national income by adding up all
the expenditure made on goods and services during a
year.
 Thus, the national income is found by adding up different
types of expenditure by households, private business
enterprises and the government.
 Computation of GDP under expenditure method
 GDP (Y) = C + I + G + (X – M)
27
3) Expenditure Method:
Components of GDP under expenditure method

GDP (Y) = C + I + G + (X – M)
 Consumption Expenditure (C) – This means expenditure for
households for food, shirt, education, automobile, refrigerators etc.
 Expenditure for investment (I)–This means business
investment. Example-: Purchase of machinery for a factory,
purchase of a software, construction of new factory etc.
 Government Expenditure (G) – This includes salaries for
government employees, purchase of weapons for military etc.
 Exports (X) – Goods and services sent to other nations.
 Imports (M) – Goods and services received from other nations.
28
Practical Exercise
In each of the following cases, determine how much GDP
and each of its components is affected.
 Mr. Hamood spends 300 OMR for the lunch of his family at a restaurant in
Muscat.
• Since Mr. Hamood spends for food here, it is consumption expenditure and
GDP of the country will increase for 300 OMR.
 Ms. Safiya spends 360 OMR for purchasing a laptop to use in her
business.
• Here the expenditure is for business, so it is investment and GDP of the
country will increase for 360 OMR.
 Mr. Mustafa bought a photocopier machine for 450 OMR for his printing
business. He got last year’s model on sale for a great price from a local
manufacturer.
• Here the expenditure is for business, so it is investment. Since the
photocopier has produced in last year it will not be considered in current
year GDP calculation. So the Investment and GDP values will not be
29
changed.
Practical Exercise
Calculate the GDP-
 Assume that Oman’s GDP consists of coconuts.
 Out of that, 7 tones of its GDP is imported,
 87 tones are consumed,
 10 tones go for government purchases to feed the army;
 6 tones go into domestic investment.
 In addition, there is 4 tons that is exported to other countries.
 Calculate the GDP of Oman according to this composition.
 Answer-
 GDP (Y) = C+I+G+(X-M)
 GDP (Y) = 87+6+10+ (4 – 7) = 100 tons of coconuts.
30
PROBLEMS IN CALCULATION OF NATIONAL INCOME
1) The Problem of Double Counting

2) The Problem of Transfer Payments
3) Problems arising from the Arbitrary Definition of
Income
4) Problems of Self-Consumed Production
5) Problems of Barter Economy
31
1) The Problem of Double Counting:
The Problem of Double Counting:

 In national income calculation, only the value of final
goods and services is calculated.
 Many goods go through many stages before reaching
market.
Example: wheat changed into bread. In this case only the
value of bread is calculated in the National Income.
Calculating the value of wheat and the value of bread will
be double counting.
32
2) The Problem of Transfer Payments:
The Problem of Transfer Payments:

 An example of transfer payments is pension.
 The receiver of pension does not produce anything for
this money.
 So this transfer payment should not be included in the
National Income calculation.
33
3) Problems arising from the Arbitrary Definition of
Income:
Problems arising from the Arbitrary Definition of
Income:
 Service rendered by housewives is not included in
national income.
 But if the same services are done by another servant
maid; it is calculated in national income.
34
4) Problems of Self-Consumed Production:
Problems of Self-Consumed Production:

 Ahmed produces dates. He does not sell these dates in
the market.
 But these dates are used for his family.
 In this example, the value of the date is not calculated in
national income because these dates are used for self-
consumption.
35
5) Problems of Barter Economy:
Problems of Barter Economy:

 When goods are exchanged for goods, such transactions
are not included in national income.
 For example: the value of opium, bought and sold in
black market is not calculated in national income.
36
NOMINAL GDP
 Nominal GDP means it is the money value of gross

domestic product in current price.
 It is the value of all final output produced in an economy
during a given year, calculated using the present price in
which the output is produced.
 It will include all the changes in current market prices that
have happened due to inflation or deflation.
 So, nominal GDP, it is not corrected for inflation.
 Nominal GDP
= Current Year Price x Current Year Output
37
NOMINAL GDP
Practical Exercise
(Compute nominal GDP in each year)
Mango Dates
Year Price Quantity Price Quantity
2005 $10 400 $2.00 1000
2006 11 500 2.50 1100
2007 12 600 3.00 1200
38
NOMINAL GDP
Here in order to calculate the Nominal GDP for each year the total value of products
have to be computed in the following way.
Mango Dates
2005 $10 400 $2.00 1000
2006 11 500 2.50 1100
2007 12 600 3.00 1200
 Nominal GDP= Current Year Price x Current Year Output
 Nominal GDP for 2005: ($ 10 x 400) + ($ 2 x 1000) = $ 6,000

 Nominal GDP for 2006: ($ 11 x 500) + ($ 2.50 x 1100) = $ 8,250
 Nominal GDP for 2007: ($ 12 x 600) + ($ 3 x 1200) = $ 10,800
41
NOMINAL GDP
Percentage changes in the nominal GDP can be calculated by using the
following formula: -
 Percentage Changes in GDP = New GDP Value ― Old GDP Value X 100
Old GDP Value
 Percentage Changes in Nominal GDP for 2005 - $ 6,000 = NIL

 Percentage Changes in Nominal GDP for 2006
 = $ ((8,250 -6000) /6000 ) X 100 = 37.5 %
 Percentage Changes in Nominal GDP for 2007
 = $ ((10, 800 -8250) /8250 ) X 100 = 30.9%
44
NOMINAL GDP
Here in order to calculate the nominal GDP for each year the total value of products have to
be computed in the following way.
 Normally the Nominal GDP doesn’t give a true picture about the total
GDP of country because of the changes in the current market price
of goods and services (inflation or deflation).
 So in nominal GDP calculation, inflation or deflation affects the total
GDP. For example, the nominal GDP of country B has given in the
following table.
45
NOMINAL GDP
Banana Apple
1990 1 5 6 5
1991 2 5 6 5
 Nominal GDP= Current Year Price x Current Year Output
 Nominal GDP for 1990: 1 x 5 + 6 x 5 = 35

 Nominal GDP for 1991: 2 x 5 + 6 x 5 = 40
46
NOMINAL GDP
 In the above table the market value of goods and services produced
by country ‘B’ has increased but output has not increased.
 So the above growth in the GDP of country ‘B’ is not due to rise in
the output but only due to inflation and the true picture of the GDP
has not reflected in the calculation. This is the reason why the
concept of Real GDP came into existence
47
REAL GDP
 Real GDPs measures what a country has really produced. Thus, it

shows the original or true picture about the output of a country.
 It is calculated using the prices of a base year. Real GDP is
corrected for inflation.
 Real GDP = Base Year Price x Current Year Output
 For example, if 1990 were chosen as the base year, then real GDP
for 1995 is calculated by taking the quantities of all goods and
services purchased in 1995 and multiplying them by their 1990
prices.
48
REAL GDP
Practical Exercise
 1. Compute Real GDP in each year, using 2005 as the base year.
Orange Dates
2005 OMR 10 400 OMR 2.00 1000
2006 11 500 2.50 1100
2007 12 600 3.00 1200
49
REAL GDP
Practical Exercise
Orange Dates
2005 OMR 10 400 OMR2.00 1000
2006 11 500 2.50 1100
2007 12 600 3.00 1200
 Real GDP= Base Year Price x Current Year Output
 Real GDP for 2005: OMR 10 x 400 + OMR 2 x 1000 = 6,000

 Real GDP for 2006: (10 x 500) + (2 x 1100) = 7,200
 Real GDP for 2007: (10 x 600) + (2 x 1200) = 8,400
 Here the Real GDP has been calculated by using 2005 as the base
year. So the price changes in goods were not affected in the total
GDP. That means, it is corrected for inflation.
50
Real GDP
Percentage changes in the Real GDP can be calculated by using the following
formula: -
 Percentage Changes in GDP = New GDP Value ― Old GDP Value X 100
Old GDP Value
 Percentage Changes in Real GDP for 2005: OMR 6,000 = Nil
 Percentage Changes in Real GDP for 2006

= OMR ((7200 - 6000) /6000 ) X 100 = 20 %
 Percentage Changes in Real GDP for 2007

= OMR ((8400-7200) /7200 ) X 100 = 16.67%
51
CHAPTER 2 THE CIRCULAR FLOW OF INCOME
REVIEW QUESTIONS
1) Define households and firms.
2) Explain circular flow of income through Simple Economy Model.
3) What is the difference between real flow and money flow?
4) What is National Income?
5) Distinguish between GDP and GNP.
6) Why measuring national income is important? Discuss.
7) Explain the different methods of measuring national income.
8) What are the problems in calculating national income of a country?
9) What is the difference between Real GDP and Nominal GDP?
53
CHAPTER 2 THE CIRCULAR FLOW OF INCOME
REVIEW QUESTIONS
 10) Compute Nominal and Real GDP in each year and find
percentage changes in the GDP. (Use 2001 as base year)
• Orange Dates
2001 6 100 1.50 800
2002 7 150 2.00 900
2003 8 200 2.50 1000
54
REFERENCES
mics
mics

3 GDP AS A MEASURE OF WELFARE
PRINCIPLES OF
MACROECONOMICS
PowerPoint® Slides
by Ron Cronovich

 Topics covered:
 GDP as a Measure of Welfare
 Alternative Approaches to Measure Welfare
1
Introduction
 GDP AS A MEASURE OF WELFARE
 Economic welfare is comprehensive measure of the

general state of economic well- being.
 Economic welfare improves when production of all the
goods and services grows.
 However, the growth of real GDP does not provide a full
and accurate measure of the changes in economic
welfare.
2
GDP AS A MEASURE OF WELFARE
 Limitations of the GDP Concept
1) Over adjustment for inflation

2) Household production
3) Underground economic activity
4) Health and life expectancy
5) Leisure time
6) Environment quality
7) Social justice.
3
Limitations of the GDP Concept:
1) Over adjustment for inflation
• The price indexes used to measure inflation give us an

upward –biased estimate of true inflation.
• If we overestimate the rise in prices, we underestimate
the growth of real GDP.
• For example, when car prices rise because cars have got
better features like safety, fuel efficiency, better comfort
etc. the CPI and the GDP deflator may count the price
rise as inflation.
• So what is really an increase in production is counted as
an increase in price rather than an increase in real GDP.
4
2) Household production
• An enormous amount of production takes place every day

in our homes.
• They are all productive activities that do not involve
market transactions and are not counted as part of GDP.
5
3) Underground Economic Activity

 The underground economic activities are purposely
hidden from the view of the government in order to avoid
taxes.
 These goods are illegal and not reported.
 Thus, it is omitted from GDP.
6
4) Health and Life Expectancy
 Good health and a long life – the hopes of every one – do

not show up in real GDP.
 Increase in real GDP over the years has increased our
life expectancy.
 However, we face new challenges like AIDS and drug
abuse.
 If we take these negative influences into account, we see
that the real GDP growth overstates the improvements in
economic welfare.
7
5) Leisure Time
 Leisure Time
 Leisure time is an economic good that adds to our
economic welfare.
 Other things being equal, the more leisure we have, the
better off we are.
 Our working time is valued as part of GDP, but our leisure
time is not. Over the years, leisure time has steadily
increased,
 But these improvement in economic well-being are not
reflected in real GDP.
8
6) Environment Quality
 Economic activity directly influences the quality of the

environment.
 The depletion of exhaustible resources, the mass
clearing of forests, and the pollution of lakes and rivers
are other major environmental consequences of industrial
production.
9
7) Inequalities
 Inequalities
 A country might have a very large real GDP per person,
while it is distributed inequitably where small elite enjoy
vast wealth and the big majority live in abject poverty.
 Such an economy would generally be regarded as having
less economic welfare than one with more equitable
distribution of income.
10
ALTERNATIVE APPROACHES TO MEASURE WELFARE
 In view of the shortcomings mentioned above there have

been various attempts to develop more accurate and
reliable indicators in order to measure social well-being.
 Among others these alternative approaches include
following approaches-
1) Human Development Index (HDI),
2) Gross National Happiness Index (GNH), and
3) Social Progress Index (SPI).
11
1) Human Development Index:

 An indicator that focuses specifically on people and their
capabilities to assess the development and welfare of a
country.
 In particular, it measures achievements in three critical
dimensions:
• Health and life expectancy,
• Education,
• Standard of living.
12
2) Gross National Happiness Index:

 An index that takes a holistic and psychology based
approach to measuring social welfare.
 It was developed in Bhutan and builds on four pillars:
• Governance,
• Socio-economic development,
• Cultural preservation,
• Environmental conservation.
 This index gives better result in measuring welfare.
13
 3) Social Progress Index: An extensive framework that is

based on three key dimensions: basic human needs,
foundations of well-being, and opportunity.
 Again, social progress for each of those dimensions is
measured by a multitude of indicators.
Those include:
• Nutrition,
• Medical care, and safety (basic human needs), education,
• Wellness, and sustainability (foundations of well-being),
and
• Personal rights, freedom, and tolerance (opportunity).
14
CHAPTER 3 GDP AS A MEASURE OF WELFARE
REVIEW QUESTIONS
1) Explain the limitations of GDP as measure of welfare.

2) What are the alternative approaches for measuring welfare?
16
REFERENCES
mics
mics
17
4 PRICE LEVEL AND NATIONAL INCOME IN THE SHORT RUN AND LONG RUN.
(AGGREGATE DEMAND AND AGGREGATE SUPPLY MODEL)
PRINCIPLES OF
MACROECONOMICS
PowerPoint® Slides
by Ron Cronovich

 Topics covered:
 Introduction
 Aggregate Demand
 Aggregate Supply Curve
 Macroeconomic Equilibrium
1
Introduction
 PRICE LEVEL AND NATIONAL INCOME IN THE SHORT RUN
AND LONG RUN. (AGGREGATE DEMAND AND AGGREGATE
SUPPLY MODEL)
 One of the most important issues in macroeconomics is the

determination of the overall price level.
 The AS-AD model uses the concepts of aggregate supply and
aggregate demand to determine real GDP and the price level
2
AGGREGATE DEMAND
 Aggregate demand is the total amount of

intended spending on a nation’s final goods and
services by its households, firms, the
government sector, and foreigners.
 Composition of Aggregate Demand: The
demand for goods and services is composed of
expenditures by households (consumption, C),
businesses (investment, I), government
(government purchases, G), and foreigners (net
exports, EX – IM). Aggregate demand, then, is
composed of these elements:
 Y=C+I+G+X–M 3
AGGREGATE DEMAND CURVE
 The aggregate
demand curve
depicts the negative
relationship between
the quantity of
aggregate output (real
GDP) demanded and
the aggregate price
level (P)

Changes in Aggregate demand
 A change in any factor that influences buying plans other than price
brings a change in aggregate demand. The main factors are:
1) Expectations
2) Fiscal policy and monetary policy
3) The world economy
The Fig. below illustrates changes in aggregate demand
Y
140 -
130 -
120 -
110 -
100 -
90 - AD1
AD 0
AD2
0 6.0 6.5 7.0 7.5 8.0 8.5 X

Real GDP(in trillions of Rials)
5
AGGREGATE SUPPLY CURVE
 Aggregate supply is the total output of final

goods and services (real GDP) produced by the
economy and an aggregate supply curve shows
the relationship between the quantity of
aggregate output that producers are willing and
able to supply and the aggregate price level (P).
6
 There is only one aggregate demand curve,
Whereas the aggregate supply curve’s behavior
depends intimately on the particular time period
being considered.
 To study aggregate supply, we distinguish
between two-time frames:
1) Long-run aggregate supply
2) Short-run aggregate supply

The Long Run and the Short Run
 The long run is a period of time that is
sufficiently long to permit resource markets to
adjust fully to a change in the aggregate price
level.
 Whereas, in the short run, resource markets do
not have sufficient time to adjust fully to a
change in the aggregate price level.
 Hence, we have two aggregate supply curves—
the long-run aggregate supply curve and the
short-run aggregate supply curve.

LONG RUN AGGREGATE SUPPLY CURVE
It shows the long-run relationship between aggregate output and
the aggregate price level.
Long -run aggregate supply (LRAS) curve is vertical. Real

GDP is unaffected by price level changes in the long run.
9
Factors That Can Shift the Long-Run
Aggregate Supply Curve
There is a strong conceptual link between the LRAS curve and the
production possibility frontier and the factors that can shift the LRAS
curve are the same ones that can shift the production possibility
frontier—improvements in the quantity or quality of resources
and improved technology.
The LRAS curve will shift to the right
10
SHORT RUN AGGREGATE SUPPLY
CURVE
It shows the short-run relationship between aggregate output and
the aggregate price level.
The Slope of the Short-Run Aggregate Supply Curve: In general, there is a

positive short-run relationship between aggregate output and the aggregate
price level. Higher prices induce greater production.

Factors That Can Shift the Short-Run Aggregate
Supply Curve
 There are numerous other factors can influence the

economy’s short-run ability to produce.
 Changes in factors such as resource costs, taxes and
the amount of regulation imposed on producers,
temporary changes in productivity, and expectations
about inflation will all have only a short-run influence on
aggregate supply, as will temporary supply-side shocks
such as strikes, weather conditions, terrorist attacks, and
trade embargos.

Factors That Can Shift the Short-Run Aggregate
Supply Curve
 Looking at the list of factors, increases in resource costs

such as wages or the price of imported oil due to
depreciation in the value of the domestic currency,
additional excise, sales, or payroll taxes, or more
stringent regulation will all conspire to increase the per-
unit cost of production, causing the SRAS curve to
shift to the left.
 Productivity improvements will have the opposite
effect, reducing per-unit costs, and driving the SRAS
curve to the right

Factors That Can Shift the Short-Run
Aggregate Supply Curve

Movements along the LAS and the SAS curves
 When the price level, the money wage rate and other resource
prices rise by the same percentage, relative prices remain
constant and the real GDP remains at potential GDP. There is a
movement along the LAS curve.
 When the price level rises but the money wage rate and other
resource prices remain constant, the quantity of real GDP supplied
increases and there is a movement along the SAS curve
Price Level LAS
140 SAS
130
120
110
100
90
0
6.0 7.0 8.0 X
GDP (trillion of Rials 2003)
15
Changes in Aggregate Supply
 Aggregate supply changes when influences on production plan other

than price level change.
 When potential GDP changes, both long run aggregate supply and
short run aggregate supply change. Potential GDP changes for three
reasons:
1) change in the full-employment quantity of labour
2) change in the quantity of capital
3) advance in technology
16
Changes in Aggregate Supply
 An increase in potential GDP increases both long run aggregate

supply and short run aggregate supply and shifts both aggregate
supply curves rightward from LAS0 to LAS 1 and from SAS0 to
SAS1.
LAS 0 LAS1
Y
Price
140 SAS0
130
SAS1
120
110
100
90
0 6.0 7.0 8.0 GDP X
17
MACROECONOMIC EQUILIBRIUM
 The purpose of the Aggregate supply –aggregate demand model is

to explain changes in real GDP and the price level.
 To achieve this purpose, we combine aggregate supply and
aggregate demand and determine macroeconomic equilibrium.
1) Short run Macroeconomic equilibrium
2) Long run Macroeconomic equilibrium
 We begin our study of macroeconomic equilibrium by looking at short

run equilibrium.
18
1) Short run Macroeconomic equilibrium
 The short run macroeconomic equilibrium occurs at point where the
aggregate demand (AD) and aggregate supply (AS) are equal. In the
fig. below the short run macroeconomic equilibrium occurs at point c
where the price level is 110 and the real GDP is 7.0 trillion.
 If the price level is 120 and the real GDP is 8 trillion, firms will not be
able to sell their output. They will decrease production and cut prices.
 If the price level is 100 and the real GDP is 6 trillion, people will not
be able to buy all the goods and services they demand. Firms will
increase production and raise their prices.
 Only when the price level is 110 and the real GDP is 7 trillion can
firms sell that they produce, and people buy all that they demand.
This is the short run macroeconomic equilibrium.
19
Short run Macroeconomic equilibrium
Short run Macroeconomic equilibrium
Price level
Y
140 -
SAS
130
120 -
110 - C
100
90 -
AD
0 6.0 6.5 7.0 7.5 8.0 8.5
Real GDP (in trillions of Rials )

20
Long run Macroeconomic equilibrium
2) Long run Macroeconomic equilibrium
 The fig. below shows the long run equilibrium which occurs at the
intersection of the aggregate demand curve and the long run
aggregate supply curve. The SAS curve intersects the LAS curve at
the long run equilibrium price level.
Y LAS
PRICE LEVEL
SAS
110
AD
Real GDP
21
REFERENCES
mics
mics

5 FISCAL AND MONETARY POLICY
PRINCIPLES OF
MACROECONOMICS
PowerPoint® Slides
by Ron Cronovich

Topics covered:
Economic Policy
Fiscal Policy & Types
Monetary Policy & Types
Budget & Types
1
ECONOMIC POLICY
 Actions designed to influence the economy by
controlling the level of aggregate demand and
money supply.
 implemented and administered by the
government.
 Examples
• taxation,
• government spending and borrowing,
• interest rate and
• exchange rate changes etc.
2
Objectives of Economic Policy
 Economic growth:
 Overall increase in economic activities, level of income
and peoples standard of living.
 Full employment:
 Every member of the labor force who wants to work is
able to find work.
 Price stability:
 Prevent frequent changes in general price level in the
form of inflation and deflation.
3
Types of Economic Policy
The governments can affect the macro economy through

two policy channels.
1) Fiscal policy
2) Monetary policy
4
1) FISCAL POLICY
This is referred to as government expenditure and taxation

policy.
TYPES OF FISCAL POLICY

1) Expansionary Fiscal Policy
2) Contractionary Fiscal Policy
5
1) Expansionary fiscal policy –
Expansionary fiscal policy –

•It is designed to control deflation
• by increasing the level of aggregate demand.
•For that government reduces taxes and increases the
public expenditure.
•It will increase the purchasing power
•When people spend more aggregate demand will
increase and then prices will start to increase.
• So there is no deflationary pressure.
6
2) Contractionary fiscal policy –
Contractionary fiscal policy –

1) It is designed to control inflation
by decreasing the level of aggregate demand.
2) For that government increases taxes and decrease
the public expenditure.
3) It will decrease the purchasing power;
4) When people spend less aggregate demand will
decrease and then prices will start to decrease.
So there is no inflationary pressure.
7
2) MONETARY POLICY
MONETARY POLICY
 Monetary policy refers to the policy through which the monetary
authority expands or contracts the money supply in the economy.
 In other words, it relates to changes in the rate of interest and the
availability of credit in the economy.
TYPES OF MONETARY POLICY

1) Expansionary Monetary Policy
2) Contractionary Monetary Policy
8
1) Expansionary Monetary Policy –
Expansionary Monetary Policy –
 Expansionary monetary policy increases the supply of money.
 It aims to control deflation.
 For that the central bank reduces the bank rate, rate of interest and
reserve requirements.
 Then the lending capacity of banks will be increased and hence
peoples purchasing power increases and thus the problem of
deflation may disappear.
 Buying of government securities in the open market by the central
bank also creates the same effect because people get their money
back.
9
2) Contractionary Monetary Policy
Contractionary Monetary Policy –
 Contractionary monetary policy reduces the supply of
money. It aims to control inflation.
 For that the central bank increases the bank rate, rate of
interest and reserve requirements.
 Then the lending capacity of banks will be decreased and
hence peoples purchasing power decreases and thus the
problem of inflation may disappear.
 Selling of government securities in the open market is
another method of contractionary policy.
10
The Budget
 A budget may be defined as a financial plan or statement

of the government which shows in details the estimated
receipts and proposed expenditures and disbursements
(payments) under various heads for the coming year.
 In other words, a budget is a description of the fiscal
policies of the government–taxation and expenditure
policies—and the financial plans in accordance to these.
 A budget indicates the revenue and expenditure of the
last completed financial year, the probable revenue and
expenditure estimates for the current year and the
estimates of the anticipated revenue and proposed
expenditure for the next financial year
11
Types of Budget
Balanced Budget and Unbalanced Budget
 A budget can be balanced or unbalanced.
 According to Dalton, “a balanced budget is that, over a
period of time, revenue does not fall short of
expenditure. If expenditure exceeds revenue, the budget
is said to be unbalanced.”
 In other words, a budget is balanced when government’s
tax revenue and expenditure are equal. Thus, in case of
balanced budget:
Revenue = Expenditure
12
Surplus Budget and Deficit Budget
 When a budget shows that government income
and expenditure are not equal, it is said to be an
unbalanced budget.
 This imbalanced may be due to an excess of
expenditure over income or an excess of income
over expenditure.
 In the former case, it results in deficit budget and
in the latter case, a surplus budget.
 Thus, excess of income over expenditure is
called a surplus budget.
13
 A surplus budget decreases liabilities of the
government. Hence, in case of surplus budget:
Revenue > Expenditure
 A deficit budget increases liabilities of the
government. Therefore, in case of deficit budget:
Revenue < Expenditure
14
CHAPTER 5 FISCAL AND MONETARY POLICY
REVIEW QUESTIONS
1) What is budget?
2) Distinguish between surplus budget and deficit budget.
3) Define economic policy. Explain its objectives.
4) What is fiscal policy?
5) Explain the tools and types of fiscal policy.
6) What is monetary policy?
7) Explain the tools and types of monetary policy.
16

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1 Introduction of Economics

© 2007 Thomson South-Western, all rights reserved

1.5 Central Problems of an Economy

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 1

 Scarcity is central to economic theory.

 For example, one can have more money by

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 4

 The word ‘Economics’ was derived from the

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 5

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 7

 He called all the earlier definitions as classificatory and

 According to him, “Economics is the science which

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 9

 The subject matter of economics is divided into

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 13

 1. What goods and services are to be produced?

 2. How to produce these goods and services?

 3. For whom these goods and services are to be

 4. Are the resources efficiently used?

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 19

© 2007 Thomson South-Western, all rights reserved

 National income, output, and expenditure are generated

 Households: Households are the suppliers of factors of

 New spending (C) generates new income (Y), which

 Thus the spending and income keep on circulating around

1. Simple Economy Model

Simple Economy Model (Two Sectors Model)

Here we have two markets in this circular

Introduction of National Income

 Measurement of National Income refers to the calculation

 National Income refers to total ‘national output’

Importance of Measuring National Income

Measuring the level and rate of growth of national income is

1) To know the rate of economic growth of a country.

1) Gross Domestic Product (GDP)

1) Gross Domestic Product (GDP)

2) Gross National Product(GNP)

3) Net National Product (NNP)

4) Net Domestic Product (NDP)

Net Domestic Product (NDP)

 GDP is the total market value of goods and services

5) Personal Income (PI)

6) Disposable Personal Income (DPI)

 Disposable Personal Income

7) Per Capita Income (PCI)

 Production generate incomes which are again spent on

Output or Production Method:

Components of GDP under expenditure method

1) The Problem of Double Counting

The Problem of Double Counting:

The Problem of Transfer Payments:

Problems of Self-Consumed Production:

Problems of Barter Economy:

 Nominal GDP means it is the money value of gross

(Compute nominal GDP in each year)

Year Price Quantity Price Quantity

2005 $10 400 $2.00 1000

2006 11 500 2.50 1100

2007 12 600 3.00 1200

 Nominal GDP= Current Year Price x Current Year Output

 Nominal GDP for 2005: ($ 10 x 400) + ($ 2 x 1000) = $ 6,000

 Percentage Changes in Nominal GDP for 2005 - $ 6,000 = NIL

 Nominal GDP= Current Year Price x Current Year Output