Unit I- Introduction to Macroeconomics

 Introduction to Macroeconomics
 Concept and Importance of macroeconomics
 Scope and Limitations of Macroeconomics
 Importance of Macroeconomics
 Macroeconomic Variables
 Aggregate Demand and Aggregate Supply
 Effective Demand
 Consumption Function
 Savings and Investment Function
 Investment Multiplier
 Equilibrium Income Determination
 Macroeconomics Concept and Importance
 It is that part of economic theory which studies the economy in its totality or as
a whole.
 It studies not individual economic units like a household, a firm or an industry
but the whole economic system. Macroeconomics is the study of aggregates and
averages of the entire economy.
 Such aggregates are national income, total employment, aggregate savings and
investment, aggregate demand, aggregate supply general price level, etc.
 Here, we study how these aggregates and averages of the economy as a whole
are determined and what causes fluctuations in them. Having understood the
determinants, the aim is how to ensure the maximum level of income and
employment in a country.
 In short, macroeconomics is the study of national aggregates or economy-wide
aggregates.
 Macroeconomics
 The subject matter of macroeconomics revolves around determination of the
level of income and employment, therefore, it is also known as ‘Theory of Income
and Employment
 When government’s participation through monetary and fiscal measures in the
economy has increased very much, use of macro analysis has become
indispensable.
 Correct economic policies formulated at macro level have made it possible to
control business cycles (inflation and deflation)
 Macroeconomic thought has enabled us to properly organise, collect and analyse
the data about national income and coordinate international economic policies.
 The scope of macroeconomics includes the following parts:
 Importance of Macroeconomics
 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.
 Limitations of Macroeconomics
 Some of the important limitations of microeconomics are listed below:
 Considers Aggregates as Homogenous:
 Misleading
 Fallacy of Deductive Inferences:
 Conceptual and Statistical Complexities:
 Unnecessary Aggregate Variables:
 Neglects Individual Consumers:
 Too Much Generalization:
 Conclusion
Macroeconomics is the basis of various
economic reforms and the national decision
model in a country. However, the policies framed under this concept usually have a
dual impact, i.e., on the society as a whole and individual citizens.Therefore, it
requires a highly analytical, logical and extraordinary approach while reaching to such
interferences.
 Macroeconomic Variables
 Aggregate Demand
 Aggregate Supply
 Consumption Function
 Savings and Investment Function
 Investment Multiplier
 Income Determination in Closed and open Economy
 Effective Demand
 Aggregate Demand
 Aggregate demand refers to the total demand for final goods and services in
the economy.
 Since aggregate demand is measured by total expenditure of the community
on goods and services, therefore, aggregate demand is also defined as ‘total
amount of money which all sectors (households, firms, government) of the
economy are ready to spend on purchase of goods and services.
 Alternatively, it is the total expenditure which the community intends to
incur on purchase of goods and services.
 Thus, aggregate demand is synonymous with aggregate expenditure in the
economy. If the total intended (i.e., ex-ante) expenditure on buying all the
output is larger than before, this shows a higher aggregate demand.
 Components of Aggregate Demand
 Components of AD:
 Thus, the main components of aggregate demand (aggregate expenditure)
in a four sector economy are:
 1. Household (or private) consumption demand. (C)
 2. Private investment demand. (I)
 3. Government demand for goods and services. (G)
 4. Net export demand. (X-M)
 Thus,
 AD = C + I + G+(X-M)
 All the variables represent planned (ex-ante) and not actual (ex-post).
 Aggregate Supply and Its Components
 Aggregate Supply and its Component
 Aggregate supply is the money value of total output available in the economy
for purchase during a given period.
 When expressed in physical terms, aggregate supply refers to the total
production of goods and services in an economy. It is assumed that in short
run, prices of goods do not change and elasticity of supply is infinite.
 Aggregate Supply = Output = Income
 Components:
 Main components of aggregate supply are two, namely, consumption and
saving. A major portion of income is spent on consumption of goods and
services and the balance is saved. Thus, national income (Y) or aggregate
supply (AS) is sum of consumption expenditure (C) and savings (S).
 Put in the form of an equation:
 AS = C + S, i.e., Y = C + S
 Consumption Function
 Concept of Consumption Function:
 J. M. Keynes first introduced the term ‘consumption function’ in 1936 to
describe the relationship between household’s planned consumption expendi-
ture and all the above forces that determine it.
 The relation between consumption and income was called by J. M. Keynes
the consumption function and is expressed as: C = f(Y), where C is
consumption and Y is income.
 The Aggregate Consumption Function:
 Every individual or household has its own consumption function. The function
shows how its desired consumption expenditure varies with its income. By
adding up the consumption functions of all households we arrive at the
aggregate consumption function which is of interest to us in macro-
economics. It shows how the total desired consumption spending of all
households varies with national income.
 Characteristics of Consumption Function
 1. Most poor people find it difficult to save because they spend the major
portion of their income on consumption goods. So income must reach a min-
imum level for any saving to occur. In other words, there is a break-even level
of income. It is the level of income at which households spend all of their
income on consumption goods, neither more nor less, i.e., at which saving is
zero.
 Below the critical (break-even) level people plan to spend in excess of their
current income either by borrowing or by dissaving,
 Once income crosses the break-even level, people plan to consume only a
portion of their income and to save the remaining portion of it.
 If income increases (decreases), consumption spending will also increase
(decrease) though not proportionately.
 These are Keynes’ four basic assumptions about the dependence of
consumption and saving on income.
 Consumption Function
 Autonomous consumption is defined as the expenditures that consumers
must make even when they have no disposable income. These expenses
cannot be eliminated, regardless of limited personal income, and are deemed
autonomous or independent as a result.
 Induced consumption is the portion of consumption that varies with
disposable income. When a change in disposable income “induces” a change in
consumption on goods and services, then that changed consumption is called
“induced consumption”.
 The concept of propensity to consume (i.e., willingness to consume) or the so-
called consumption function is based on a ‘fundamental psychological law’
which states that “men are disposed, as a rule, and on an average, to
increase consumption as their income increases but not by as much as the
increase in their income.”
 Consumption Function
 Consumption function equation:
 Consumption function (linear, i.e., straight line consumption function) is represented by the
following equation.
 C = C + bY
 Where C represents total consumption, C represents autonomous consumption (i.e.,
minimum consumption for survival when income is zero), b shows marginal propensity to
consume (i.e., consumption increases by b for every rupee increase in income. Thus, 0 < b <
1). Y stands for level of income. Clearly, C is assumed to be positive (+) because for survival
there has to be some consumption even when there is no income.
 Thus, total consumption (C) comprises two components:
 (i) Autonomous consumption (C) not influenced by income and
 (ii) Induced consumption (bY) influenced by income.
 For example, the consumption equation C = 30 + 0.75Y means Rs 30 is autonomous
consumption (C) and 0.75 is marginal propensity to consume (b). Further, as income
increases, 75% of addition income (indicating 0.75Y) is spent on consumption. In short,
consumption equation C = C + bY shows that consumption (C) at a given level of income (Y)
is equal to autonomous consumption (C) + b times of given level of income.
 Consumption Function
 Propensity to Consume

 APC is the ratio of consumption to income. It is the proportion of income that is

consumed. It is worked out by dividing total consumption expenditure (C) by total
income (Y).
 Symbolically,
 APC = C/Y
 MPC measures the response of consumption spending to a change in income. It is
the ratio of change in consumption to a change in income. It is worked out by
dividing the change in consumption by the change in income.
 Symbolically,
 MPC = ∆C/∆Y

 Savings Function
 As propensity to consume refers to willingness to consume so does propensity to
save refers to willingness to save. Saving is the difference between income and
planned consumption, i.e.,
 S=Y–C
 Saving function is derived from the consumption function. Planned saving is a
function of aggregate disposable income, i.e.,
 S = f (Y)
 Keynes’ saving function has the following characteristics:
 i. Saving is a stable function of disposable income.
 ii. Saving varies directly with disposable income.
 iii. The rate of increase in saving is less than the rate of increase in income. At
very low levels of income as well as at zero income, since consumption is positive,
saving must be negative. As income increases, dissaving vanishes and saving
becomes positive. In Keynes’ terminology, this feature suggests that the value of
the marginal propensity to save (MPS) is positive but less than one.
 Propensity to Save
 APS is the proportion of income devoted to savings. It is obtained by dividing
total saving by total income, i.e.,
 APS = S/Y
 Or, APS = Y – C/Y (S = Y – C)
 When income and consumption are equal, APS becomes zero. Now, if income
increases, APS would tend to rise. MPS is the change in saving consequent
upon a change in income. It is the proportion of any addition to income that
is used for saving. Symbolically,
 MPS = ∆S/∆Y
 The value of MPS is always less than one.
 Relationship between APC and APS
 A part of income is consumed while another portion of it is saved by people. So, if we know
the value of APC or MPC, we can easily find out the value of APS or MPS.
 APC = C/Y
 APS = S/Y = Y – C/Y = 1 – C/Y
 (... S = Y – C)
 Or, APS = 1 – APC
 As APC and APS are complementary terms their sum must be equal to one.
 We know that
 Y=C+S
 Now, dividing both sides of this equation by Y, we obtain
 Y/Y = C/Y + S/Y
 1 = APC + APS
 Or, APS = 1 – APC
 When APC rises (or falls) APS falls (or rises). When APC = 1, APS must be equal to zero, and
when APC = 0, APS = 1. But since APC can never be zero, so APS can never be equal to one. It
must be less than one.
 Relationship between MPC and MPS
 We calculate MPS from MPC. To do so, first we show that the sum of MPC and
MPS is equal to one and MPS must be (1 – MPC). This is because income is
always equal to consumption plus saving. Or
 Y=C+S
 Now, suppose, income changes to ∆ Y. As a result, both consumption and
saving change to ∆C and ∆S, respectively, i.e.,
 ∆Y = ∆C + ∆S
 Dividing both sides of this equation by ∆ Y we get
 ∆Y/∆Y = ∆C/∆Y + ∆S/∆Y
 Or, 1 = MPC + MPS
 or, MPS = 1 – MPC
 When MPC rises (falls) MPS must fall (rise) in such a manner that their sum
becomes equal to one.
 Investment Function
 The level of income, output and employment in an economy depends upon
effective demand, which in turn, depends upon expenditures on consumption
goods and investment goods (Y = C + I).
 Out of the two components (consumption and investment) of income,
consumption being stable, fluctuations in effective demand (income) are to be
traced through fluctuations in investment.
 Investment, thus, comes to play a strategic role in determining the level of
income, output and employment at a time.
 In order to maintain an equilibrium level of income (Y = C + I), consumption
expenditures plus investment expenditures must equal the total income (Y)
 As income increases consumption also increases but by less than the increment in
income.
 The savings must be invested to bridge the gap between an increase in income
and consumption.
 If there is no increase in investment expenditures, it would result in intended
increase in the stocks of goods (inventories), which in turn, would lead to
depression and mass unemployment.
 Investment
 In Keynesian economics investment means real investment i.e., investment in
the building of new machines, new factory buildings, roads, bridges and other
forms of productive capital stock of the community, including increase in
inventories.
 It does not include the purchase of existing stocks, shares and securities,
which constitute merely an exchange of money from one person to another.
 Such an investment is merely financial investment and does not affect the
level of employment in an economy.
 An investment is termed real investment only when it leads to a increase in
the demand for human and physical resources, resulting in an increase in
their employment.
 Investment is a flow variable and its counterpart is stock variable called
capital.
 Investment
 Investment may be private investment or public investment, it may be
induced or autonomous.
 Induced investment is that investment which changes with a change in
income, that is why it is called income, elastic. Induced investment increases
as income increases.
 Induced investment is undertaken specially to produce large output.
 Autonomous investment is independent of variations in output. Autonomous
investment is not sensitive to changes in income.
 Autonomous Investment is independent of income changes and is not guided
or induced by profit motive only. These investments are made primarily by
the Government and are not based on considerations of profit.
 Autonomous investments are a peculiar feature of a war or a planned
economy Prof. Hansen maintained that autonomous investment is generally
associated with such factors as introduction of new production techniques,
products, development of new resources or growth of population.
 Investment
 The curve of autonomous investment is represented by a straight line running
from left to right and parallel to the horizontal income axis.
 The shape of the induced investment curve, is upward sloping, indicating a
rise in investment as a result of rise in income.

 Investment increases productive capacity which, in turn, raises the level of

output, employment and income.
 Investment Multiplier
 When investment increases by a certain amount, aggregate income increases
by a multiple of that investment. This multiple is called multiplier.
 Investment multiplier shows a relationship between initial increment in
investment and the resulting increment in national income.
 Multiplier (K), thus, is the ratio of increase in national income (∆Y) due to an
increase in investment (∆I).
 Symbolically
 K = ∆y/∆I or ∆Y = K x ∆I
 Where K = Investment multiplier, ∆Y = change in income, ∆I = change in
investment.
 Investment multiplier indicates the multiplying effect of investment on
income.
 Relationship of K with MPC and MPS
 Since multiplier indicates the effects of change in investment (∆I) on change
in income (∆Y), therefore, K = ∆Y/∆I = ∆Y/∆Y/∆C.
 By dividing by ∆Y

 K = 1/1-MPC = 1/MPS
 There is direct relationship between K and MFC. If MPC is high, K will also be
high but if MPC is low, K will also be small
 Value of K depends upon value of MPC or MPS. MPC cannot be negative, it can
be at the most zero (minimum value) and maximum value can be 1.
 Between the two extremes (1 and infinity), value of multiplier varies
depending upon value of MPC
 Effective Demand
 The principle of ‘effective demand’ is basic to Keynes’ analysis of income,
output and employment.
 The Principle of Effective Demand tells us that in the short period, an
economy’s aggregate income and employment are determined by the level
of aggregate demand which is satisfied with aggregate supply.
 Effective Demand is the demand for the output as a whole; in other words,
out of the various levels of demand, the one which is brought in equilibrium
with supply in the economy is called effective demand.
 Effective demand represents the money actually spent by- people on goods
and services. The money which the entrepreneurs receive is paid to the
factors of production in the form of wages, rent, interest and profit.
 As such, effective demand (actual expenditure) equals national income
which is the sum of the income receipts of all members of the community.
 Effective Demand
 It also represents the value of the output of the community because the total
value of the national output is just the same thing as the receipts of the
entrepreneurs from selling goods.
 Further, all output is either consumption goods or investment goods; we can
therefore say that effective demand is equal to national expenditure on
consumption plus investment goods.
 Thus, effective demand (ED) = national income (Y) = value of national output
= Expenditure on consumption goods (C) + expenditure on investment goods
(I).
 Therefore, ED = Y = C + I= 0 = Employment.
 The principle of effective demand occupies an integral position in the
Keynesian theory of employment.
 Importance of Effective Demand
 The concept of effective demand has established beyond doubt that whatever
is produced is not automatically consumed nor is the income spent at a rate
which will keep the factors of production fully employed.
 Secondly, in Keynes’ view, as level of employment depends upon the level of
effective demand, wage cuts may or may not increase employment.
 Thirdly, the Principle of Effective Demand could explain as to how and why a
depression could come to stay.
 Fourthly, it puts the spotlight on the demand side. In contrast to the classical
emphasis on the supply side, Keynes placed major emphasis on demand side
and traced fluctuations in employment to changes in demand. The theory of
effective demand makes clear how and why aggregate demand becomes
deficient in a capitalist economy and how deficiency of effective demand
generates depression.