MacroEconomics

Session 8-14
• What is Business Cycle
– A historical phenomena
– Economywide fluctuations in total national output, income and
employment, usually lasting for a period of 2 to 10 years, marked by
widespread expansion or contraction in most sectors of the economy.
• Textbook definition of Recession:
– recurring period of decline in output, income and employment, usually
lasting for 6-12 months and have contraction in many sectors
• Depression: A recession that is large in both scale and duration
• Characteristics of Recession:
– Investment falls sharply. Housing price became stagnant or falling ….
decline in consumption durables…production falls, GDP falls
– Employment usually falls sharply in early stages of recession and
sometimes slow to recover.
– As output falls, inflation slows and demand for crude materials declines,
material price falls
– Wages and prices of services are likely to be stagnant
– Business profits fall sharply in recession
• Reasons for Business Cycle
– Exogenous Theories: factors outside the economic system
• Wars, Revolutions and Elections (Aggregate Demand change)
• Oil prices, Population migration, discoveries of new lands and resources
• In scientific breakthroughs and technological innovations
(Aggregate Supply Change)
– Internal Theories look for mechanisms within the economic
system
– In this approach, every expansion breeds recession and
contraction
– Source in US: Financial crisis
– Source in Developing Countries:
• Typically Balance of Payment Crises percolated to Financial crises
• Result in investment pessimism, fall in Aggregate Demand.
– Typical Business Cycle:
• Frenzied Investment guided by ‘Animal Spirit’
• Over investment….profit does not catch up…investment pessimism
starts… fall in Aggregate Demand.
 Components of Aggregate Demand…1
• Real Consumption:
– primarily determined by disposable income, which is
personal income minus taxes
– Other factors are longer term trends in income, household
wealth and aggregate price level
• Investment:
– Includes purchase of buildings, software, equipment and
accumulation of inventories
– Major Determinants are-
• Level of output
• Cost of capital (determined by tax policies, interest rate and other
financial conditions)
• Expectation about the future
• Monetary policy by changing interest rate can influence
investment
 Components of Aggregate Demand…2
• Government Purchases:
– includes purchase of school books, medicine in Govt. Hospitals,
fighter jet plane, judges salary etc.
– It is a policy decision of the Govt.
• Net Exports or Exports - Imports:
– Imports are determined by –
• domestic income and output
• Ratio of domestic to foreign prices
• Exchange Rate
– Exports (import by foreigners) determined by-
• foreign income and output
• Ratio of domestic to foreign prices
• Exchange Rate

• Hence, Net Exports determined by?

 Aggregate Demand
• Total or aggregate quantity of output that is
willingly bought at a given level of prices,
other things held constant.
• Why it is negatively slopped?
– When price rises, some elements of personal
income or wealth does not go up
– Therefore, real disposable income falls
– Consumption falls
– Aggregate Demand falls
Many Factors can Increase Aggregate Demand and Shift
Out the AD Curve -
Figure a: Aggregate Demand changes due to price changes
Figure b: Aggregate Demand changes without changing the prices
 Business Cycle and Aggregate Demand

Business cycle fluctuations are often caused by shifts in

aggregate demand
 Is the Business Cycle Avoidable?

 Since, post-1945 to 1970s business cycle disappeared

 Era of Demand Management

 1970s to late 1990s fluctuations due to supply side factors

 Oil shocks and dot.com boom

 Credit-led housing boom - Followed by collapse

 Need for Demand Management

 What is Multiplier Model?

 Explains how output is determined in the short run.

 Each Rs. change in exogenous expenditure leads more than 1 Rs.

Change (or a multiplied change) in GDP.

 The key assumptions –

 underlying are wages and prices are fixed
 Unemployed Resources in the economy

For Simplicity,

 we are ignoring the role of monetary policy,

 Assume financial market does not react to economic change and

 no international Trade and Finance

Multiplier Model or Simple Keynesian Model

It tells us how
investment
and
consumption
spending
interact with
income to
determine
national
output.
 Meaning of Equilibrium
• An equilibrium is a situation where different forces at work are
balance
• Suppose, if you see ball rolling down a hill, the ball is not in
equilibrium. It is in disequilibrium
• When the ball comes to the rest in a valley, at the bottom of the hill
forces operating on the ball are in balance. Therefore, an
equilibrium
• Similarly, in macroeconomics equilibrium level of output is one
where the different forces of spending and output (supply) are in
balance
• At the graph of next slide, the point E is equilibrium.
• At point E and only at point E, does desired spending C+I equals
actual output
• At any other point, the business will find either producing too much
or too little, hence will want to get at point E.
 The Multiplier
• The multiplier is impact of Rs. 1 change in exogenous
expenditure on total output
• In this simple model where expenditure = C+I,
• In other words, multiplier = ΔY/ΔI
• Equilibrium condition-
 Y = C +Io
 Now, C = a+bYd
 Hence, Y = a+b(Y-T) +Io
 Y =(a-bT)/(1-b) + Io /(1-b)
 Y = a/(1-b) – bT/(1-b)+ Io /(1-b)
 ΔY/ΔI = 1/(1-b)
0 < b <1, Hence, 1/(1-b) > 1
What is the economic logic behind value of multiplier >1?
 Changes in Equilibrium Income
Multiplier is ΔY/ΔI = 1/(1-b)
• How it operates:
• pd1: ΔI= ΔE = ΔYd → ΔC=b ΔYd → Δ2C = b2 ΔYd →Δ3C = b3ΔYd
→….
• Total Increase in Expenditure or aggregate demand: ΔE +ΔC + Δ2C
+ Δ3C ……..
• Or, total increase in income, ΔY= ΔE+b ΔYd+ b2 ΔYd+ b3ΔYd…..

• As ΔI = ΔE = ΔYd

• We can write, ΔY = (1+b+b2+b3……). ΔI

• Or, ΔY = [1/(1-b)]. ΔI
Similarity and Dissimilarity
between Keynesian Cross
or Multiplier with AS-AD
model

Key assumption
is prices and
wages are fixed.
 Tax Multiplier

• Condition for a equilibrium level of Income,

Y = E = C+I+G,
I, G are autonomous expenditure so given, So is T
Y is endogenous variable,
C = a + b Yd = a + bY – bT,
So, Y = a + bY – bT +I + G
So equilibrium income Ȳ = (a-bT +I +G)/(1-b)
1/(1-b) is autonomous expenditure multiplier
(a-bT +I +G) is autonomous expenditure
ΔY/ΔT = – b/(1-b)
Why Tax Multiplier is negative?
How Tax Multiplier Operates:
pd1: ΔT= ΔYd → ΔC=b ΔYd → Δ2C = b2 ΔYd →Δ3C = b3ΔYd
→….
Total decline in Expenditure or aggregate demand: -ΔC - Δ2C -
Δ3C ……..
Or, total decline in income, ΔY = - b ΔT - b2 ΔT - b3ΔT…….
= -bΔT (1+ b + b2…………..)
= -bΔT/(1-b)
So, ΔY/ ΔT = -b/(1-b)

If we introduce Government Expenditure

for increase in Govt. Expenditure the increase in income is

ΔY = [1/(1-b)]. ΔG Govt. Expenditure Multiplier

If Fiscal Deficit is zero, what is the value of Multiplier ?

Balanced Budget Multiplier, ΔY̅/ΔG + ΔY̅/ΔT = 1

 Multiplier in Open Economy
• Condition for a equilibrium level of Income,
Y = E = C+I+G +X - M,
I, G, X are autonomous expenditure so given, So is T
Y is endogenous variable, Import Function, M = n + mY
C = a + b Yd = a + bY – bT, m is marginal propensity to import,
M = n + mY, n is average propensity to import

So, Y = a + bY – bT +I + G + X -n - mY
So equilibrium income Y = (a-bT +I +G +X -n)/(1-b+m)
1/(1-b+m) is autonomous expenditure multiplier
(a-bT +I +G +X -n) is autonomous expenditure

So, ΔY/ΔT = – b/(1-b+m ) Tax Multiplier

ΔY/ΔI = 1/(1-b+m) Autonomous Investment Multiplier
ΔY/ΔG = 1/(1-b+m) Govt. Expenditure Multiplier
ΔY/ΔX = 1/(1-b+m) Export Multiplier
 Home Task
Suppose, it is Simple Keynesian Economy or Keynesian cross
Economy (not closed). The GDP of this economy is Rs. 30 lakh crores.
Consumption, Investment and Gov expenditure are of Rs. 10 lakh crores
each. For an increase of Rs. 1 lakh in GDP, Rs. 30 thousand consumption
increases.

Case1: Suppose Government increases its expenditure (in domestic

economy) by 1 lakh crores by borrowing this amount from the external
market. But the exchange rate remains unchanged. What will be the impact
on GDP?

Case2: Suppose Government increases its expenditure (in domestic

economy) by 1 lakh crores by borrowing 50 thousand crores from the
domestic market and remaining 50 thousand crores by imposing tax on
household. (exchange rate remains unchanged.) What will be the impact on
GDP?
Government Accounts
 Budget Structure…1

Revenue Account Capital Account

Receipt Expenditure
Receipt Expenditure
Tax Developmental Mkt. loans Developmental
Ext. Debt
Non-Tax Small Savings
Non-Developmental
Provident fund Non-Developmental
Contri. by PSU Interest Payment
Interest Receipt Defence Exp.
Fiscal Service Organs of State
Fiscal Services
Gen. Services Admin. Services

Social & Comm services Subsidy to FCI

Social Security, Welfare Pension
Econ Services Subsidy to FCI
Ext. Grants Grants to UT
 What is Revenue Deficit?
• Revenue Deficit = Revenue Receipts – Revenue Expenditure

• Revenue Receipts = Tax receipts +Non-Tax Receipt (interest, dividend

from PSUs, fees, Stamp duties, external grants)

• Revenue Expenditure = Cost of running Govt. (Govt. Consumption Expenditure) +

Interest + Subsidies Cost

• Govt. Consumption expenditure includes expenditures on salaries and administration for

the normal running of dept. (like defense, police, postal, economic, social, other general
services and central plan)
Transfer Payment includes expenditure on subsidies, interest payment,
pensions.
• Revenue Expenditure can also divided into
• Development
• Non-Development Expenditure
 Net Capital Expenditure
• Net Capital Expenditure = Capital Expenditure - Capital Receipt

• Capital Expenditure as Expenditure on acquisition of assets of material

and permanent character
= Expenditure on public infrastructure, (i.e. roads, structures &
equipment used in Govt.), Govt. investment in shares, loans to
PSUs.
• This can also be divided into Development and Non-Development

• Capital Receipt = Non-debt receipt +debt receipt

• Non-debt Receipt = Loans and Advance recovery, Proceeds from

PSUs Disinvestment etc.
• Debt Receipt = Public Borrowing
 Various Concepts of Deficits…

• What is Fiscal Deficit?

• Fiscal Deficit = Revenue Deficit + Capital Expenditures
- Non-debt Receipt
It measures how much the Govt. has to borrow

• Primary Deficit = Fiscal Deficit – interest payment

• Monetised Deficit = Fiscal Deficit – Govt. borrowing

 Tax Receipts…1
• Direct or Income Tax & Indirect Tax

• Direct Tax two kind

– Personal income and corporate income
• Indirect Tax:
Tariff or customs duty
Goods And Service Tax (GST)
Excise Duty only in 5 products including petrol-
VAT Diesel and Alcohol
 Tax Receipts…2
• Personal income is proportional tax on Income

• Corporate income is proportional tax on profit

• Tariff or customs duty is proportional tax on value of imported Goods

• Goods and Service Tax (Tax collected at each stage of value addition)

• Excise Duty is proportional tax on the value of produced goods at the

factory gate.

• VAT is Tax collected at each stage of value addition in producing Goods

Thank You
Aggregate Supply Curve
 Aggregate Supply Curve
• Aggregate Supply describes the behavior of the production side of the economy
• It is the schedule showing the level of total national output that will be produced at each possible price level,
other things held constant

• Short-run Aggregate Supply Schedule: In the short run, prices and wages have elements of inflexibility. As a
result, higher prices associated with higher production of output.
• So, either horizontal or upward-sloping AS curve

• Long-Run Aggregate Supply Schedule : price and wage adjust with each other fully (if wages are above the
subsistence wage)
• Output of the economy equals to the potential output and is independent of prices. So Vertical AS curve.

• Aggregate Supply Depends upon Potential Output and Production Costs

AS Shifts
 Expected Inflation

• Expected rate of inflation is built into the economy’s Institutions-

• Comes out of Inflation inertia
• Some examples that create inertia-
– The Dearness Allowance System
– MSP
– Limit to annual increase in school fees
– Minimum selling price of sugar

Core Inflation: Inflation without food and energy prices

Demand Pull Inflation
Cost-Push Inflation and Stagflation
Thank You