Macroeconomics: Basic

Points
ALOK RAY
 About me.
 3 announcements
 Why theory, not just facts?
 Difference between Microeconomics and Macroeconomics
 2 parts: Explanatory and Policy.
 Macro is not a simple summation of micros.
Ex: Saving, Wage cut.
 Many models with different assumptions.
 2 extreme models:
(a) Flex-price Fix-output (“Classical”), Supply-determined
equilibrium.
(b) Fix-price Flex-output (“Keynesian”), Demand-
determined equilibrium.
 Actual GDP depends on 3 factors: (1) Resources (L, K,
Land); (2) Rate of utilization of resources (Full
employment, excess capacity); (3)
Productivity/Technology.
 In short run: (1) and (3) given, (2) determined by AD.
 In long run: (2) at full employment level thru wage-price
flexibility. So, growth of (1) and (3) determines growth and
trend of GDP over time. [Show slide of Trend vs.
Fluctuations in GDP].
 Consensus: “Classical” model appropriate for
studying longer-term issues like trend growth rate of
GDP. “Keynesian” model appropriate for studying
short-run issues like fluctuations in GDP and
employment around the trend.
 Next, a few basic concepts.
 GDP = Value, at market prices, of all final goods and
services produced within the geographic boundary of
India, in a year or a quarter.
 GNP = GDP + net factor earnings (wages, interest, profits)
from abroad (can be +ve or -ve)
 GDP a better indicator of employment situation.
 GNP (or per capita GNP) a better indicator of the standard
of living in country
 Similarly, a difference between SDP of a state
(Maharashtra or Kerala) and the income of a state = SDP +
net income received from outside.
 For a closed economy: GDP = GNP.
 GDP is all of the following:
(a) Value of Total Production of goods and services
(b) Total Income of the country
(c) Total Expenditure of the country.
 A simple circular flow diagram.
 Rules for computing GDP.
 Is GDP a good measure of aggregate national economic
activity? (Exclusions, Valuation issues)
 Is per capita GDP a good measure of average standard of
living? (Distribution of income)
 International comparison of GDP and per capita GDP.
 Official vs. PPP exchange rate. My DH article on: What
does India being fastest growing economy mean?
 My DH article on: What does India being fastest growing
economy mean?
 Different measures – closely related – of Income and
Output
 NNP = GNP – Depreciation (of machines and buildings)
 Part of market price taken away by govt in the form of
indirect taxes (GST, Excise tax, customs duty) – Rest
distributed to factor of production as income.
 So, we get: National Income or NNP at factor cost = NNP -
indirect taxes + price subsidies (treated like negative taxes.
Ex: subsidy on essential drugs or electricity which reduces
the market price below factor cost)
 Now make a distinction between income accruing to
households and small business (personal sector) and
corporate business firms.
 Personal Disposable Income = GNP – ALL taxes (direct and
indirect) + ALL subsidies – Undistributed profits (i.e. profits
that remain with the firms) + Transfers from govt (like
pensions, unemployment benefits) – Transfers to govt (like
PF contributions) + Transfers from abroad (like remittance
from abroad)
 Real Vs. Nominal GDP (or Money GDP).
 Alternative measures of inflation: GDP Deflator, CPI,
WPI, Core Inflation. Food Inflation. Related Issues.
 Concepts: Labor Force, Unemployment Rate,
Recession, Inflation and Deflation, Recession and
Depression. Full employment, Output Gap.
 Components of AD. How different components
important for different countries.
 Identity vs. Equilibrium condition. S=I. Planned vs.
Unplanned quantities or Ex-ante vs. Ex-post.
 NI Identity in Open Economy. Link between “Twin
Deficits”.
 Real and Nominal GDP
Year Nominal GDP Price Index(P) Real GDP
2010 20,000 100 20,000 (Real & Money GDP same in Base year)
2020 30,000 200 15,000
Real GDP in 2020 = (30,000/200) x 100 = 15,000. [2010 = Base year]
Nominal or Money GDP has gone up by 50% but Real GDP has fallen. Because, %
rise in P > % rise in Nominal GDP.
Note: Nominal GDP (GDP at current prices) = Value of all goods and services
produced in that year at current prices.
Real GDP (GDP at constant prices) = Value of all goods and services produced in
that year at constant prices or prices in base year.
(Nominal GDP/P) x 100 = Real GDP where P = 100 in base year.
If any 2 of above variables are known, the 3rd variable can be derived.
 Different Price Indexes or “Deflators”
• GDP Deflator: P that we get from (Money GDP/ Real GDP) x 100.
• CPI or Cost of living Index: Gives cost of buying a fixed basket of goods that a
typical consumer buys in base year. CPI calculated for different classes of
workers, like industrial workers, agr. labor, urban non-manual workers etc.
• WPI : Gives cost of all commodities (a fixed basket as in base year) at wholesale
prices (not retail as in CPI) including intermediate goods (machines, raw
materials).
• “Core Inflation”: Inflation excluding more volatile food and fuel prices.
Measures inflation caused by excess demand (rather than “imported” or due to
supply side factors ) which is more amenable to monetary policy.
• Headline inflation: Official measure of inflation in India. Used to be WPI, now
CPI. RBI monetary policy targeted at a range of CPI (like 4% +/- 2%).
 CPI and GDP Deflator
• Major differences:
• A) GDP Deflator includes prices of all domestically produced goods including intermediate
goods like machines (but not imported goods).
• B) CPI includes prices of all imported goods purchased by consumers.
• C) CPI measures the cost of a fixed basket of goods as in base year. But GDP Deflator allows
weights to change from year to year, depending on composition of GDP. Ex: GDP Deflator for
2019 = (Q2019 x P2019) / (Q2019 x P2010). For 2020, it is = (Q2020 x P2020) / (Q2020 x P2010).
• Note difference in Quantity weights for different years. [Base year: 2010].
• Substitution bias of CPI: CPI gives higher weight to more expensive goods relative to what
consumers would actually buy, in response to changes in relative prices and hence overstates
the rise in cost of living. Ex: Price of apples going up relative to oranges. Consumers would buy
less apples and more oranges but CPI does not change the quantity weights.
• Other problems: New goods (accounted in GDP Deflator but not in CPI); quality change (A 2020
cell phone different from one in 2010 – like fall in price), accurate sample of prices (different
varieties of same goods like rice, cars). Should change base year frequently.
OFFICIAL EXCHANGE RATE VS. PPP
EXCHANGE RATE
If same basket costs $1 in US and Rs. 25 in
India, PPP ER = $1: Rs. 25, though OER
may be $1: Rs. 75.
Why? Labor-intensive services like haircut
very cheap in India. May cost Rs. 50 in India
but $25 in US. Implies a PPP ER (for
haircut): $1: Rs. 2.
For internationally tradable goods like Apple
phones, cost is $1,000 in US and Rs. 75,000 in
India, implying a PPP ER (for Apple
phones): $1: Rs. 75.
OFFICIAL EXCHANGE RATE VS. PPP
EXCHANGE RATE (Contd.)
For a basket with many tradables and non-
tradables, it may be $1: Rs. 25.
Significance:
Say, India’s GDP = Rs.150 tr. = $2 tr. @Rs.
75: $1 (OER)
But, India’s GDP = Rs.150 tr. = $6 tr. @Rs.
25: $1 (PPP).
So, India’s GDP or per capita GDP goes up 3
times if use PPP ER instead of OER.
COMPONENTS OF DEMAND/EXPENDITURE WITH
GOVT AND TRADE
Y=C+I+G+X–M
LHS: Production/Supply of Indian goods.
RHS: Components of demand for Indian goods.
By Def., 2 sides must be equal if quantities refer to actual/ex-
post quantities rather than planned/ex-ante quantities.
Y- C = I + G + X – M
(Y– Yd) + (Yd – C) = I + G + X – M
T+S=I+G+X–M
(S – I) = (G - T) + (X – M)
[BD] [TS] where BD is Budget Deficit, TS is
Trade Surplus.
COMPONENTS OF DEMAND/EXPENDITURE WITH
GOVT AND TRADE (Contd.)
Suppose, (S – I) = 0.
Then (G - T) = (M – X) or BD = TD where (M – X) is
TD = Trade Deficit.
(+10) (+10)
“Twin Deficit” concept: BD implies TD.
More generally,
(G - T) = (S – I) + (M – X)
(+10) = (+15) + (-5). In this case, no “Twin Deficit”.
Lesson: Everybody can’t afford to be extravagant
without creating a TD.
COMPONENTS OF DEMAND/EXPENDITURE WITH
GOVT AND TRADE (Contd.)
Alternatively, S + (T - G) = I + (X – M)
Private Saving + Govt Saving = Domestic Investment +
Trade Surplus.
3 Uses of Private Sector Saving S:
S = I + (G – T) + (X – M)
where S = Private Saving, I = Domestic Investment in India,
(G – T) = Budget Deficit or Govt using Private Saving, (X –
M) = Trade Surplus = Capital Export = Investment Abroad
or Foreign Investment by India.
Ex: China: Massive trade surplus and $ earning invested
in/lent to USA (by buying US Govt bonds/factories/real
estate/strategic industries in USA). US, richest country in
the world, borrowing from China to finance a trade deficit
and maintain an artificially high standard of living.