UNIT 1

Introduction to Macroeconomics
 Macroeconomics is the branch of economics that deals with the structure, performance,
behaviour, and decision-making of the whole, or aggregate, economy.
 The two main areas of macroeconomic research are long-term economic growth and
shorter-term business cycles.
 Macroeconomics is the study of large-scale economic issues, such as inflation, GDP
(GDP), and unemployment. It helps form the basis of a large part of government
economic policy.

Economy:
An economy is a complex system of interrelated production, consumption, and exchange
activities that ultimately determines how resources are allocated among all the participants.
The production, consumption, and distribution of goods and services combine to fulfil the
needs of those living and operating within the economy.
An economy may represent a nation, a region, a single industry, or even a family.

Development
Development is a process that creates growth, progress, positive change, or the addition of
physical, economic, environmental, social and demographic components. The purpose of
development is a rise in the level and quality of life of the population, and the creation or
expansion of local regional income and employment opportunities, without damaging the
resources of the environment. Development is visible and useful, not necessarily
immediately, and includes an aspect of quality change and the creation of conditions for a
continuation of that change.

Why we need to study Macro Economics?

Macro Economics is aggregative economics which examines the interrelation among various
aggregates, their determination and causes of fluctuations in them.
The practical importance of macroeconomics has been carefully analyzed in points below.
 Various national problems like overpopulation, inflation, balance of payment is
underpinning the underdeveloped economies. The study of macroeconomics helps to
bring a check on these issues.
 Macroeconomics enables studying the causes, effects, and solutions of general
redundancy.
 The study of macroeconomics is very important for evaluating the overall performance
of the economy in terms of national income.
 Macroeconomics helps to evaluate the resources and capabilities of an economy, churn
out ways to increase the national income, boost productivity, and create job
opportunities to upscale an economy in terms of monetary development.
 Correct economic policies formulated at macro level makes it possible to control
business cycles (inflation and deflation) and resultantly, violent booms and depressions
rarely occur.
 Macroeconomics as a discipline includes diverse theories of consumption and saving. It
explains the importance of saving in the national economy and its role in the
investment.
Theory of Employment and Income (https://www.mgkvp.ac.in/Uploads/Lectures/28/6641.pdf)
 Income and employment are the main concern of the economy. Both are
interdependent also. In the other words the level of income depends on the level of
employment and similarly, the level of employment depends on the level of income.
 The classical economists provide a system of the determination of income and
employment. Which is called the classical theory of income and employment
determination.
Assumptions of the Theory
 Long run analysis.
 Laissez Fair / Free or no intervention of the government or any authority.
 Perfect competition in the commodity and factor market. Full employment: In the long
run, there is always full employment situation in the economy.
 Market law: “Supply creates its own Demand.”
 Level of income and employment are interrelated by the production function.
Classical Model
The classical economists held the view that the economy consists of three market-
- Labor Market
- Goods Market, and
- Money Market
It was argued that the operation of forces of supply and demand in each of these markets
would finally result in full employment.
The classical system can be represented by the following set of equations:
Equations of the Model

Y = Real Output
N = Employment
W= Money Wage Rate
P = General Price Level
M = Quantity of Money
K = Fraction of income that is demanded to be held in cash
balance.

Graphical Explanation of the Model

 In the figure (1), determination of employment level through
demand and supply in the factor market has been explained.
 Demand of employment is a decreasing function of the real wage
rate and supply of employment is an increasing function of the
real wage rate.
 In the figure (2), determination of real output has been explained
through production function Y = f (N).
 At the pre determinate level of employment equilibrium output is
 Where OP functional represents the relationship between Output
and Employment.
 In the figure (3), the determination of money income is
explained. At the given Price level, quantity of money and fixes
proportion K we can convert real output into money income
through given equation: M = KPY.

UNIT 2
Theory of Economic Growth: Four wheels of Growth - Human resources, Natural
resources, Capital & Technological Changes
Human Resources – the working population’s expertise, training, and education directly
impact a country’s growth. A competent, well-trained labor force is more efficient,
delivering high-quality production which contributes to an economy’s effectiveness. A lack
of skilled labor may be a barrier to sustainable growth. An underutilized, undereducated,
and unqualified employee would become an economic constraint and contribute to higher
unemployment.
Physical Capital – enhancements and increased physical capital expenditure, such as
roadways, infrastructure, and factories, would lower costs and enhance economic
production quality. Industrial units and modern machinery, which are upgraded and
properly maintained, are more efficient than manual labor. Increased productivity leads to
higher output, and work becomes more productive as the ratio of capital spending per
employee increases. Improving labor output will definitely enhance the rate of economic
growth.
Natural Resources – the rate of economic growth is influenced by the quantities and
availability of natural resources. The exploration of more minerals, like oil reserves or
minerals, would improve the economy by increasing its production potential. A country’s
success in using and managing its natural wealth is a feature of the labor force’s expertise,
the nature of technology, and capital availability. Therefore, professional and trained
workers can use these natural resources.
Technology – technology enhancements have a high effect on economic development. As
the scientific world progresses, management finds ways to use these growths as more
advanced manufacturing standards. Applying improved technology means that the same
amount of labor will be more efficient, and at lower prices, and economic development will
progress. Countries that understand the importance of these four factors would have higher
growth rates and better living conditions for their citizens. Technological progress and
greater education for the workforce would increase economic development, resulting in a
better living environment for all.
Central Bank and its functions
Central bank is regarded as an apex financial institution in the banking system. It is
considered as an integral part of the economic and financial system of a nation. The central
bank functions as an independent authority and is responsible for controlling, regulating,
and stabilizing the monetary and banking structure of the country.
In India, the Reserve Bank of India is regarded as the central bank. It was set up in 1935.
Central banks are responsible for maintaining the financial stability and economic
sovereignty of the country.

The functions of a central bank can be discussed as follows:

Currency regulator or bank of issue: Central banks possess the exclusive right to
manufacture notes in an economy. All the central banks across the world are involved in
issuing notes to the economy. This is one of the most important functions of the central
bank in an economy and due to this the central bank is also known as the bank of issue.
Earlier all the banks were allowed to publish their own notes which resulted in a
disorganized economy. To avoid this situation the government around the world authorized
the central banks to function as the issuer of currency, which resulted in uniformity in
circulation and balanced supply of money in the economy.
Bank to the government: One of the important functions of the central bank is to act as the
bank to the government. The central bank accepts deposits and issues funds to the
government. It is also involved in making and receiving payments for the government.
Central banks also offer short term loans to the government to recover from bad phases in
the economy.
In addition to being the bank to the government, it acts as an advisor and agent of the
government by providing advice to the government in areas of economic policy, capital
market, money market and loans from the government.
Custodian of Cash reserves: It is a practice of the commercial banks of a country to keep a
part of their cash balances in the form of deposits with the central bank. The commercial
banks can draw that balance when the requirement for cash is high and pay back the same
when there is less requirement of cash.
It is for this reason that the central bank is regarded as the banker’s bank. Central bank also
plays an important role in the credit creation policy of commercial banks.
Custodian of International currency: An important function of the central bank is to
maintain a minimum balance of foreign currency. The purpose of maintaining such a
balance is to manage sudden or emergency requirements of foreign reserves and to
overcome any adverse deficits of balance of payments.
Lender of last resort: The central bank acts as a lender of last resort by providing money to
its member banks in times of cash crunch. It performs this function by providing loans
against securities, treasury bills and by rediscounting bills.
This is regarded as one of the most crucial functions of the central bank wherein it helps in
protecting the financial structure of the economy from collapsing.
Clearing house for transfer and settlement: Central bank acts as a clearing house of the
commercial banks and helps in settling of mutual indebtedness of the commercial banks. In
a clearing house, the representatives of different banks meet and settle the inter-bank
payments.
Controller of credit: Central banks also function as the controller of credit in the economy. It
happens that commercial banks create a lot of credit in the economy that increases the
inflation. The central bank controls the way credit creation by commercial banks is done by
engaging in open market operations or bringing about a change in the CRR to control the
process of credit creation by commercial banks.
Protecting depositor’s interests: Central bank also needs to keep an eye on the functioning
of the commercial banks to protect the interests of depositors.

Examples of Central Banks

Some of the well-known central banks across the world are:
1. Federal Reserve (USA)
2. Reserve Bank of India (India)
3. People’s Bank of China (China)
4. Bank of England (UK)
5. European Central Bank (EU or European Union)

Monetary policy
 Monetary policy is a set of actions to control a nation's overall money supply and
achieve economic growth.
 Monetary policy strategies include revising interest rates and changing bank reserve
requirements.
 Monetary policy is commonly classified as either expansionary or contractionary.
 The Federal Reserve commonly uses three strategies for monetary policy including
reserve requirements, the discount rate, and open market operations.
Types of Monetary Policy
Monetary policies are seen as either expansionary or contractionary depending on the level
of growth or stagnation within the economy.
Contractionary
A contractionary policy increases interest rates and limits the outstanding money supply to
slow growth and decrease inflation, where the prices of goods and services in an economy
rise and reduce the purchasing power of money.
Expansionary
During times of slowdown or a recession, an expansionary policy grows economic activity.
By lowering interest rates, saving becomes less attractive, and consumer spending and
borrowing increase.

Goals of Monetary Policy

Inflation
Contractionary monetary policy is used to target a high level of inflation and reduce the
level of money circulating in the economy.
Unemployment
An expansionary monetary policy decreases unemployment as a higher money supply and
attractive interest rates stimulate business activities and expansion of the job market.
Exchange Rates
The exchange rates between domestic and foreign currencies can be affected by monetary
policy. With an increase in the money supply, the domestic currency becomes cheaper than
its foreign exchange.

Money supply
 The money supply is the total amount of cash and cash equivalents such as savings
accounts that is circulating in an economy at a given point in time.
 Variations of the money supply number take into account non-cash items like credit and
loans.
 In the U.S., the Federal Reserve tracks the money supply from month to month.
 The Fed also influences the money supply, through actions that increase or decrease the
amount of cash in the system.
 Monetarists, who view the money supply as the main driver of demand in an economy,
believe that increasing the money supply leads to inflation.
Determinants of the Money Supply
The big numbers of M1 or M2 contain a number of components that are analyzed by
economists to determine just how all of that money is flowing through the system and
where there might be problems. Economists speak of these components as the
determinants of the money supply. They include:
 The currency deposit ratio. That is, the amount of cash that the public at large is keeping
on hand rather than depositing in banks.
 The reserve ratio. This is the amount of cash that the Federal Reserve requires a bank to
keep in its vaults to satisfy all potential withdrawals by its customers, even in the event
of a run on the banks.
 The excess reserve. This is the amount of money that the banks have available to lend
out to businesses and individuals.
Money multiplier
 Money multiplier is a term in monetary economics that is a phenomenon of creating
money in the economy in the form of credit creation, which is based on the fractional
reserve banking system.
 Money multiplier is also known as the monetary multiplier. It is the maximum limit to
which money supply can be affected by bringing about changes in the amount of money
deposits.
 The money multiplier effect is seen in commercial banks as they accept deposits, and
after keeping a certain amount as a reserve, they distribute the money as loans for
injecting liquidity in the economy.
 The amount of money that should be kept by commercial banks in their reserve for
withdrawal purposes by the customers is referred to as the reserve ratio, required
reserve ratio, or cash reserve ratio.
Mathematically, money multiplier formula can be represented as follows:
Money multiplier = 1/r
Where r = Required reserve ratio or cash reserve ratio
 It means that if the reserve ratio is higher, then the money multiplier will be lower and
the banks need to keep more reserves. As a result, they will not be able to lend more
money to individuals and businesses.
 Similarly, a lower reserve ratio results in a higher money multiplier that allows a lesser
amount of money to be kept as a reserve and more lending opportunities to the public.

Inflation
 Inflation is the rate at which prices for goods and services rise.
 Inflation is sometimes classified into three types: demand-pull inflation, cost-push
inflation, and built-in inflation.
 The most used inflation indexes are the Consumer Price Index and the Wholesale Price
Index.
 Inflation can be viewed positively or negatively depending on the individual viewpoint
and rate of change.
 Those with tangible assets, like property or stocked commodities, may like to see some
inflation as that raises the value of their assets.
Causes of Inflation
An increase in the supply of money is the root of inflation, though this can play out through
different mechanisms in the economy. A country's money supply can be increased by the
monetary authorities by:
 Printing and giving away more money to citizens.
 Legally devaluing (reducing the value of) the legal tender currency.
 Loaning new money into existence as reserve account credits through the banking
system by purchasing government bonds from banks on the secondary market (the most
common method)
In all these cases, the money ends up losing its purchasing power. The mechanisms of how
this drives inflation can be classified into three types: demand-pull inflation, cost-push
inflation, and built-in inflation.
Demand-Pull Effect
 Demand-pull inflation occurs when an increase in the supply of money and credit
stimulates the overall demand for goods and services to increase more rapidly than the
economy's production capacity. This increases demand and leads to price rises.
 When people have more money, it leads to positive consumer sentiment. This, in turn,
leads to higher spending, which pulls prices higher. It creates a demand-supply gap with
higher demand and less flexible supply, which results in higher prices.

Cost-Push Effect
 Cost-push inflation is a result of the increase in prices working through the production
process inputs. When additions to the supply of money and credit are channeled into a
commodity or other asset markets, costs for all kinds of intermediate goods rise. This is
especially evident when there's a negative economic shock to the supply of key
commodities.
 These developments lead to higher costs for the finished product or service and work
their way into rising consumer prices. For instance, when the money supply is expanded,
it creates a speculative boom in oil prices. This means that the cost of energy can rise
and contribute to rising consumer prices, which is reflected in various measures of
inflation.

Built-in Inflation
 Built-in inflation is related to adaptive expectations or the idea that people expect
current inflation rates to continue in the future. As the price of goods and services rises,
people may expect a continuous rise in the future at a similar rate. As such, workers may
demand more costs or wages to maintain their standard of living. Their increased wages
result in a higher cost of goods and services, and this wage-price spiral continues as one
factor induces the other and vice-versa.

Anti-Inflationary Policies

Phillips curve
 The Phillips curve states that inflation and unemployment have an inverse relationship.
Higher inflation is associated with lower unemployment and vice versa.
 Understanding the Phillips curve in light of consumer and worker expectations shows
that the relationship between inflation and unemployment may not hold in the long run,
or even potentially in the short run.
 The concept behind the Phillips curve states the change in
unemployment within an economy has a predictable effect on price
inflation.
 The inverse relationship between unemployment and inflation is
depicted as a downward sloping, concave curve, with inflation on the Y-
axis and unemployment on the X-axis. Increasing inflation decreases
unemployment, and vice versa.