MACROECONOMICS (106)

Unit 1
Q1. What is macroeconomics? What are its importance and
limitations?
Ans. Macroeconomics is the branch of economics that studies the
behaviour and performance of an economy as a whole. It focuses on
the aggregate changes in the economy such as unemployment,
growth rate, gross domestic product and inflation.
Macroeconomics analysis all aggregate indicators and the
microeconomic factors that influence the economy. Government and
corporations use macroeconomic models to help in formulating of
economic policies and strategies.
Importance:
1. It helps to understand the functioning of a complicated modern
economic system. It describes how the economy as a whole
functions and how the level of national income and employment
is determined on the basis of aggregate demand and aggregate
supply.
2. It helps to achieve the goal of economic growth, higher level of
GDP and higher level of employment. It analyses the forces which
determine economic growth of a country and explains how to
reach the highest state of economic growth and sustain it.
3. It helps to bring stability in price level and analyses fluctuations in
business activities. It suggests policy measures to control Inflation
and deflation.
4. It explains factors which determine balance of payment. At the
same time, it identifies causes of deficit in balance of payment and
suggests remedial measures.
5. It helps to solve economic problems like poverty, unemployment,
business cycles, etc., whose solution is possible at macro level
only, i.e., at the level of whole economy.
6. With detailed knowledge of functioning of an economy at macro
level, it has been possible to formulate correct economic policies
and also coordinate international economic policies.
7. Last but not the least, is that macroeconomic theory has saved us
from the dangers of application of microeconomic theory to the
problems of the economy as a whole.
Limitation
1. Fallacy of Composition
In Macro economic analysis the “fallacy of composition” is
involved, i.e. aggregate economic behaviour is the sum total of
the economy of individual activities. But what is true of individuals
is not necessarily true to the fiscal entirely. For instance, savings
are a private virtue but a public vice. If total savings in the
economy increases, they may initiate a depression unless they are
invested. Again, if an individual depositor withdraws his money
from the bank, there is no risk. But if all depositors simultaneously
do this, there will be a run on the banks and the banking system
will be affected adversely.
2. To Regard the Aggregates as Homogenous
The main defect in macro analysis is that it regards the aggregates
as homogenous without caring about their internal composition
and structure. The average wage in a nation is the sum total of
wages in all professions, i.e. wages of clerks, typists, teachers,
nurses etc. But the volume of aggregate employment depends on
the relative structure of wages rather than on the average wage.
 For instance, wages of nurses increase but of typist rises much
aggregate employment would increase.
3. Aggregate Variables may not be Important Necessarily
The aggregate variables which form the economic system may not
be of much significance. For instance, income of a country is the
total of all individual income. A hike in national income does not
mean that individual income have risen. The increase in national
income might be the result of the increase in the incomes of a few
rich people in the nation. Thus a rise in the national income of this
type has little significance from the point of view of the
community.
4. Indiscriminate Use of Macro Economics Misleading
An indiscriminate and uncritical use of macroeconomics in
analyzing the complexities of the real world can frequently be
misleading. For instance, if the policy measures needed to achieve
and maintain full employment in the economy are applied to
structural redundancy in individual firms and industries, they
become irrelevant. Likewise, measures aimed at controlling
general prices cannot be applied with much advantage for
controlling prices of individual products.
5. Statistical and Conceptual Difficulties
The measurement of macro economics concepts involves a
number of statistical and conceptual complexities. These
problems relate to the aggregation of micro economic variables. If
individual are almost similar, aggregation does not present much
difficulty. But if micro economic variables relate to dissimilar
individual units, their aggregation into one aggregation into one
macro economic variable may be incorrect and hazardous.
.

Q3. (a) What are the methods of measurement of National income?

(b) Suppose the GDP at market price of a country in a particular year
was Rs 1,100 crores. Net factor income from abroad was Rs 100
crores. The value of indirect taxes and subsidies provided was Rs 150
crores. National income was Rs 850 crores. Calculate the aggregate
value of depreciation.

Ans. (a) Methods for calculating National Income

1. Value added method

The value added method is also known as the product method or

output method. Its primary objective is to calculate national income
by taking the value added to a product during the various stages of
production into account.

National income (NI) = (NDPFC) + Net factor income from abroad

2. Expenditure method

The expenditure method of national income calculation is based on

the expenditures taking place in the economy. The expenditures that
happen in an economy can be done by individuals, households,
business enterprises, and the government.

National income (NI) = C + G + I + (X – M)

Or
National income (NI) = C + G + I + NX

3. Income method
It is based on the income generated by the individuals by providing
services to the other people in the country either individually or by
using the assets at disposal. The income method takes the income
generated from land, capital in the form of rent, interest, wages and
profit into consideration. The national income by income method is
calculated by adding up the wages, interest earned on capital, profits
earned, rent obtained from land, and income generated by the self-
employed people in an economy. It is known as net domestic
product at factor cost or NDPFC.
NNPFC = (NDPFC) + Net factor income from abroad
(b) Given - GDPMP = 1,100 crores, NFIA = 100 crores
NIT = 150crores, NNPFC = 850 crores
GDPFC = GDPMP - NIT
= 1,100 - 150 = 950 crores
GNPFC = GDPFC + NFIA
= 950 + 100 = 1050 crores
NNPFC + Depreciation = GNPFC
Depreciation = 1050 - 850 = 200 crores

Q5. What is the significance of National income?

Ans. (a) A comprehensive summary of the economic activity:
National income estimates give us detailed data relating to a
country’s production, savings, investment, capital formation and
various other economic activities in a particular year. All these data
give us a comprehensive picture of the economic activities of the
people during that year.
(b) Assessment of the relative importance and progress of the
different sectors:
The national income data relating to the sources of national income
give us an idea of the relative importance of the different sectors
(namely, agriculture, industry, trade and commerce, services, etc.) in
the economy of the country.
(c) Indispensable to government for framing policies and
programmes:
The government of a country is to frame its economic policies and
programmes on the basis of the estimates of the different
components of national income. The importance of these estimates
has increased considerably in developing countries in framing their
future development plans.
(d) The pivot of economic planning:
National income estimates constitute the pivot of economic planning
as the entire machinery of planning is based on “an appraisal of
existing resources and an accurate diagnosis of deficiencies”
furnished by the national income estimates. These estimates enable
the government to determine the allocation of the country’s
resources on the different heads of development.
(e) Measurement of inflationary and deflationary gaps:
Modern economists take the help of the national income data for
measuring the inflationary or deflationary gaps found at any time in a
country.
(f) Social accounting and the framing of the budget:
National income figures serve as the background of ‘Social
Accounting’ and the government’s annual budgets are also framed in
the context of the country’s national income estimates.
(g) Measuring the rate of growth and the per capita income:
The annual rate of increase in national income is considered to be
the rate of economic growth of a country. The per capita income of
the people of a country is also calculated dividing the national
income by the total population of a country in a particular year.
(i) Comparison of living conditions:
The national income data are also very useful for comparing the
overall economic conditions, especially living conditions of the
people of the different countries and at different times.

Unit 2
Q1. Examine the Classical theory of income and employment.
Ans. The basic contention of classical economists was that “given
flexible wages and prices, a competitive market economy would
operate at full employment. That is, economic forces would always
be generated to ensure that the demand for labour would always
equal its supply”.
In the classical model the equilibrium levels of income and
employment were supposed to be determined largely in the labour
market. The demand curve for labour shows the relationship
between the real wage and the demand for labour by employers.

The lower the wage rate, the more the workers will be employed.
This is why it is downward sloping. The supply curve of labour is
upward sloping for obvious reasons. The higher the wage rate, the

greater the supply of labour.

Fig. 1 shows the labour market situation. The equilibrium wage rate
is determined by the demand for and the supply of labour. The level
of employment is OL0. The lower graph shows the relation between
total output and the quantity of the variable factor
The graph actually shows the short-run production function which
may be expressed as Q =f (KL), where Q is output, K is the fixed
quantity of capital and L is the variable factor labour. Total output is
OQ0 when OL0 units of labour are employed.

In fact, “whatever the full employment level of output, the income

created in producing it will necessarily lead to spending which will be
sufficient to purchase the goods produced”. In other words, the
classical economists denied the possibility of under-spending or
overproduction.

Q2. Critically examine the classical theory of income and

employment.
Ans. The classical theory of employment is criticized on the following
grounds:

(1)    Equilibrium Level need not be full Employment Level. At the

equilibrium level, it is not necessary that full employment may be
attained. Aggregate demand may be equal to aggregate supply at
less than full employment level. Keynes calls it ‘under-employment
equilibrium’. He points out that all the factor income generated
during the process of production need not be spent of consumption.
A part of the factor income may be saved. unless the investors are
willing to invest an amount equivalent to the amount of saving, the
total expenditure will not be equal to total output available for sale.
In such a situation, producers will not sell their entire output.
Consequently, the profit will fall and the producers will be compelled
to reduce their output which will create unemployment.

(2)    Rate of Interest is not the true Determinant of Saving and

Investment. In the classical system, both saving and investment are
the functions of the rate of interest, and therefore, equality between
saving and investment can be attuned through changes in the rate of
Interest. prof. Keynes says that decisions about saving and
investment are taken by the two fundamentally different groups of
people. Saving is not only determined by the rate of interest but also
by the level of money income. likewise, investment is not influenced
by the rate of interest alone, it also depends upon the marginal
efficiency of capital.
(3)    Theory is applicable only in the long run. Full employment
equilibrium in the classical system is attained in the long run. but,
according to prof. Keynes, “in the long run we are all dead, and after
death, there is no economic or non-economic problem. “Most of our
problems arise in the short run (particularly the problem of
employment) and their solutions must also be found in the short run.
If unemployed workers are assured good jobs after three years, the
questions arises that how will they survive for three years.

(4)    Employment and output are not eh function of wage rate.

Classical thinkers believed that the level of employment and income
can be raised by curtailing the wage rate. But, according to Keynes,
employment is not a function of wage rate but of effective demand.
Curtailment of wage rate brings a fall in aggregate demand, it will
discourage investment, as a result, the level of output and
employment will decrease.

(5)    Existence of over-production or under-production cannot be

overruled. The classical assumption of no general glut (over-
production) or under-production labour force was rendered
unemployed in the USA. The producers found it difficult to sell off all
their output and there was general glut in the economy.
(6)    Full employment is not a normal situation. The classical
assumption of full employment as a normal situation is also unreal.
According to Keynes, unemployment is a general situation and full
employment is a rare exception. Full employment is an ideal
situation which can rarely be attained by an economy.

Q4. Write the relation between saving and consumption.

Ans. GOOGLE KRLOOO

Q6. Explain the concept of marginal efficiency of capital.

Ans. MEC refers to the expected profitability of a capital asset. It
may be defined as the highest rate of return over cost expected from
the marginal or additional unit of a capital asset. First we must go to
the marginal unit of the capital asset and secondly its cost has to be
deducted from its return.

Now the MEC in its turn, depends on two factors: the prospective
yield of the capital asset and the supply price of the capital asset.
The MEC is the ratio of these two factors. The prospective yield of a
capital asset is the total net return from the asset over its life time.

The supply price of an asset is the cost of producing a brand new

asset of that kind and not the supply price of an existing asset. It is
referred to as the replacement cost. If the supply price of a capital
asset is Rs. 20,000 and its annual yield is Rs. 2000, then the
marginal efficiency of this asset is 2000/20000 x 100 = 10 percent.
Thus the marginal efficiency of capital is the percentage of profit
expected from a given investment on a capital asset.
Keynes relates the prospective yield of a capital asset to its supply
price and defines MEC “as being equal to that rate of discount which
would make the present value of the series of annuities given by the
returns expected from the capital asset during its life equal to its
supply price”. This may be put in the form of an equation.
Where Sp is the supply price or the cost of capital asset, R 1,R2… Rn
are the prospective yields or the series of expected annual returns
from the capital asset in the years 1,2…….. n, and i is the rate of
discount. This makes the capital asset exactly equal to the present
value of the expected yield from it. This can be explained with a
numerical example.

Let us assume that:

1. The life time of a capital asset (n) is 2 years.

2. The supply price of the capital asset (Sp) is Rs. 3000.

3. The expected yield from the asset at the end of one year (R1) is Rs.
1100.
4. The expected yield from the asset at the end of 2 years (R 2) is Rs.
2420.
The MEC or the rate of discount which will equate the
future yields of the asset with its supply price is 10% as
shown below:

In this way, discounted prospective yields of capital asset can be

brought into equality with the current supply price. Thus
investment will take place only if the net prospective yield of an
asset is greater than its supply price and given the income flow the
higher the supply price of the capital asset, the lower will be the rate
of discount.

Q7. Define multiplier in three sector model.

Ans. Multiplier is the numeric value that helps to determine the
change in national income due to change in autonomous investment
in an economy. It means Keynesian Multiplier, that is, Investment
Multiplier. In other words, investment multiplier reveals the action of
income to increased investment.
Government Expenditure multiplier is the numeric value that helps
to determine the change in national income due to change in
autonomous Government Expenditure in an economy. It reveals the
action of income to increased Government Expenditure.
Export multiplier is the numeric value that helps to determine the
change in national income due to change in autonomous Export in an
economy. It reveals the action of income to increased Export.
Import multiplier is the numeric value that helps to determine the
change in national income due to change in autonomous Import in
an economy. It reveals the action of income to increased import.
Tax multiplier is the numeric value that helps to determine the
change in national income due to change in autonomous Taxation in
an economy. Import multiplier reveals the action of income to
increased taxation.
Transfer Payment multiplier is the numeric value that helps to
determine the change in national income due to change in
autonomous transfer payment in an economy. Import multiplier
reveals the action of income to increased import.
So, from these definition,
Multiplier (k) = Change in Income /Change in Investment= ∆Y/∆I
Government Expenditure Multiplier (kG) = Change in Income/ Change in
Government Expenditure =∆Y /∆G
Export Multiplier (KX) = Change in Income /Change in Exports= ∆Y /∆X
Import Multiplier (KM) = Change in Income /Change in Imports=∆Y/∆M
Tax Multiplier (KT) = Change in Income /Change in Tax =∆Y/∆T
Transfer Payment Multiplier (KR) = Change in Income/ Change in Transfer
Payment=∆Y/∆R
Multiplier in Three Sector Economy
Government Sector is added to components of Two Sector Economy.
Y = C + I +G
In an Keynesian Economy,
C = Ca + Ci = Ca + b Y [b = MPC]
L=la
G = G or Gc
So, Y = Ca + bY + la + Gc
Y(1 — b) = Ca + la + Gc
Y =1/1— b x (Ca + la + Gc)
National Income equals to 1/1—b proportion of summation of
Autonomous Consumption, Autonomous Investment, and constant
Government Expenditure.
Proof of Multiplier in Three Sector Economy
Y=1/1—b* (Ca + la + Gc)
Total Income = Y + ∆Y
Total Government Expenditure = Gc + ∆G
So, Y =1/1—b* (Ca + la + Gc + ∆G)
Y + ∆Y = 1/1—b* (Ca + la + Gc + ∆G)

Y + ∆Y =1/1—b* (Ca + la + Gc) + 1/1—b* ∆G

Y + ∆Y = Y +1/1—b* ∆G
∆Y= 1/1—b* ∆G

∆Y /∆G = 1/1—b

Unit 3
Q1. Explain the concept of business cycle. what are its phases?
Ans. Business cycles are a type of fluctuation found in the aggregate
economic activity of a nation -- a cycle that consists of expansions
occurring at about the same time in many economic activities, followed by
similarly general contractions (recessions). This sequence of changes is
recurrent but not periodic.
Phases

1. Expansion
The first stage in the business cycle is expansion. In this stage, there
is an increase in positive economic indicators such as employment,
income, output, wages, profits, demand, and supply of goods and
services. Debtors are generally paying their debts on time, the
velocity of the money supply is high, and investment is high. This
process continues as long as economic conditions are favorable for
expansion.
2. Peak
The economy then reaches a saturation point, or peak, which is the
second stage of the business cycle. The maximum limit of growth is
attained. The economic indicators do not grow further and are at
their highest. Prices are at their peak. This stage marks the reversal
point in the trend of economic growth. Consumers tend to
restructure their budgets at this point.
3. Recession
The recession is the stage that follows the peak phase. The demand
for goods and services starts declining rapidly and steadily in this
phase. Producers do not notice the decrease in demand instantly and
go on producing, which creates a situation of excess supply in the
market. Prices tend to fall. All positive economic indicators such as
income, output, wages, etc., consequently start to fall.
4. Depression
There is a commensurate rise in unemployment. The growth in the
economy continues to decline, and as this falls below the steady
growth line, the stage is called a depression.
5. Trough
In the depression stage, the economy’s growth rate becomes
negative. There is further decline until the prices of factors, as well as
the demand and supply of goods and services, contract to reach their
lowest point. The economy eventually reaches the trough. It is the
negative saturation point for an economy. There is extensive
depletion of national income and expenditure.
6. Recovery
After the trough, the economy moves to the stage of recovery. In this
phase, there is a turnaround in the economy, and it begins to recover
from the negative growth rate. Demand starts to pick up due to low
prices and, consequently, supply begins to increase. The population
develops a positive attitude towards investment and employment
and production starts increasing.

Q4. What are the determinants of inflation? What are the remedial
measures taken to alter inflation?
Ans. Inflation
In economics, inflation means rise in the general level of prices of
goods and services over a period of time in an economy. Inflation
may affect the economy either in positive way or negative way.
Causes of Inflation
 Inflation may occur sometimes due to excessive bank credit or
currency depreciation.
 It may be caused due to increase in demand in relation to
supply of all types goods and services due to a rapid increase in
population.
 Inflation also may be also be caused by a change in the value of
production costs of goods.
 Export boom inflation also comes into existence when a
considerable increase in exports may cause a shortage in the
home country.
Inflation is also caused by decrease in supplies, consumer
confidence, and corporate decisions to charge more.
Measures to Control Inflation
There are many ways of controlling inflation in an economy −
Monetary Measure
The most important method of controlling inflation is monetary
policy of the Central Bank. Most central banks use high interest rates
as a way to fight inflation. Following are the monetary measures
used to control inflation −
 Bank Rate Policy − Bank rate policy is the most common tool
against inflation. The increase in bank rate increases the cost of
borrowings which reduces commercial banks borrowing from the
central bank.
 Cash Reserve Ratio − To control inflation, the central bank needs
to raise CRR which helps in reducing the lending capacity of the
commercial banks.
 Open Market Operations − Open market operations mean the
sale and purchase of government securities and bonds by the
central bank.

Q5. What are the recessionary trends and its effect on different
sectors of economy?
Ans. A recession is a macroeconomic term that refers to a significant
decline in general economic activity in a designated region. It had
been typically recognized as two consecutive quarters of economic
decline, as reflected by GDP in conjunction with monthly indicators
such as a rise in unemployment. The National Bureau of Economic
Research (NBER), defines a recession as a significant decline in
economic activity spread across the economy, lasting more than a
few months, normally visible in real GDP, real income, employment,
industrial production, and wholesale-retail sales.
Cause
The nature and causes of recessions are simultaneously evident and
uncertain. Recessions are, in essence, a cluster of business failures
being realized simultaneously. Firms are forced to reallocate
resources, scale back production, limit losses, and, usually, lay off
employees. Those are the clear and visible causes of recessions.
There are several different ways to explain what causes a general
cluster of business failures, why they are suddenly realized
simultaneously, and how they can be avoided.

Economists disagree about the answers to these questions, and

several different theories have been offered.