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Chapter 17

Macro Economic Phenomenon

Objectives
• To understand the significance of macroeconomic aspects and their impact on business. • To elaborate the circular flow of economic activity and income. • To introduce the concepts of aggregates, stock and flow, intermediary and final goods and employment. • To explain the consumption function, investment function and the marginal efficiency of capital • To understand the IS-LM theory of equilibrium

Households • Take joint decision about the consumption of goods and services. • Provide services in terms of factor inputs to the firms • Get paid for these services by firms which households spend on consumption. • It is a circular flow of money or income . • Money flows from firms to households as factor payments and from households to firms as expenditure on goods and services. • Require various factors of production to produce these goods and services.Circular Flow of Economic Activities and Income The simple model of the circular flow assumes two players Firms • Produce and supply the goods and services.

Rent. Interest and Profits) Factor Payments (Y) Factor Inputs Households Savings (S) Financial Market Investment (I) Firms Goods and Services (O) Consumption expenditure (C) In the equilibrium Y=C+S=C+I=E=O .Circular Flow of Income (Two Sector Economy) (Wages.

Circular Flow of Economic Activities and Income • Value of output produced (Y) = value of output sold (O) • Value of output sold = Sum of consumption expenditure (C) and investment expenditure (I). Y=C+S…………. Y=O=C+I=E……(1) • Income is either consumed or saved (S).(2) C+I=Y=C+S………(3) • Therefore: I = S…………(4) • Savings are withdrawal of money from the circular flow • Investment is injection of money into the circular flow • For equilibrium savings should be equal to investments • Hence Y=O=E .

Exports (X): Inflow of income takes place when foreign firms buy goods and services from domestic ones .Circular Flow of Income (Four Sector Economy) The third sector is Government (G) • Government Spending – – – On provision of public utility goods and services. Provides salaries to the households Pays to firms for purchases of goods and services Households and firms pay various taxes and other payments and provide factor inputs to the government. • Government Revenue – – The fourth sector is the external sector • • Imports (M): Outflow of income occurs when the domestic firms buy goods and services from foreign ones. Government borrows from the financial market to fill revenue gap.

Circular Flow of Income (Four Sector Economy) Government (G) Taxes Taxes Factor Payments Factor Inputs Remittances for purchases Salaries Savings (S) Households Imports (M) Financial Market Investment (I) Firms Imports (M) Goods (O) Consumption Expenditure Foreign Nations (X-M) Exports (X) Exports (X) National Income=C+I+G+(X-M) .

government and net of exports (X-M) National Income=C+I+G+(X-M) • Since national income can either be consumed. W=J • At equilibrium. or paid as tax to the government: C+I+G+(X-M)=C+S+T I+G+(X-M) =S+T • Sum of private investment and expenditure on net exports is equal to the sum of savings and tax revenue.Circular Flow of Income (Four Sector Economy) • National income includes expenditures on consumption investment. total injections are equal to total withdrawals. or saved. Thus: I+G+X =S+T+M • Therefore. .

e. consumption demand (C) • aggregate demand for capital goods i. (I). • Aggregate supply (AS) consists of – supply of consumer goods (C) and – Supply capital goods (where capital comes from savings (S). • aggregate demand (AD) for consumer goods i. Thus AD = C+I • Aggregate supply is the total national output produced and supplied by all the factors of production in an economy.Macro-economic Variables • Aggregate Demand and Aggregate Supply – Aggregate Demand is the sum of demand for all goods and services by all the consumers for a given period of time. • It refers to the supply of all goods and services in the economy for a given period of time. Hence AS=C+S .e.

over a period of time. – Flow includes the variables which increase (inflows) and decrease (outflows) the stock. Stock=Inflows-Outflows • Intermediate and Final Goods – Intermediate goods (and services) are items purchased by firms for using them in production of some other good of utility. .Macro-economic Variables • Stock and Flow – Stock may be defined as any economic variable which has been accumulated at a specific point of time. • Capital formation – The process of savings being converted into investment – Gross Capital Formation refers to the aggregate of additions to fixed assets (Fixed Capital Formation) and increase in stocks of inventories during a period of time. – Also known as producer goods because they are used as inputs in the production of other goods.

– Includes transfer payments. • A direct tax is one paid directly to the government by the persons on whom it is imposed • An indirect tax is one where incidence is on one person and impact is on someone else. . retirement pensions. etc. These include unemployment compensation.tax revenue. which refers to payments made to certain sections of the society as a social welfare measure. It is an exchange of purchasing power from one group of people to another. including Direct and Indirect Taxes and non. – Government Revenue is income received by government in various forms.Macro-economic Variables • Government Expenditure and Revenue – Government Expenditure is which is made from public exchequer.

– Frictional Unemployment occurs when an individual is out of his current job and looking for another job. – Voluntary unemployment : where a person is out of job because he is either not willing to work on the prevalent or prescribed wages or does not want to work at all.Macro-economic Variables • Employment: A person who is willing and capable to work in a productive activity and is engaged for certain number of hours per week. is employed. . • Types of Unemployment – Involuntary unemployment : where people are capable to work and willing to work at the prevailing wage rate but fail to get an opportunity. It may occur due to: – Classical Unemployment: occurs when trade unions and labor organization bargain for higher wages. whether working for self or someone else. – Structural Unemployment: occurs when there is a mismatch of skilled workers in the labour market. which leads to fall in the demand for labour. This is purely temporary phenomenon.

dispute between partners. – Seasonal unemployment occurs when certain industries and traders engage workers for a particular season such as Sugar industry. – Sudden unemployment occurs due to changes in the work place conditions. . – Disguised unemployment is one where people appear to be employed but when you remove some of them the total produce remains same. tourism and event management. or as deficient-demand unemployment. etc. this may be due to closure of the firm. Marginal productivity of labour is zero in such case. It is also referred as Keynesian unemployment.Macro-economic Variables – Cyclical unemployment is the result of the trade cycle.

apc= C/Y . mpc = dC/dY mps=dS/dY mpc+mps=1 • Average propensity to consume (apc) refers to the percentage of income that is spent on goods and services rather than on savings.Consumption Function • The aggregate consumption in any economy is the summation of consumption expenditure by all the individuals • Marginal propensity to consume (mpc) is defined as the ratio of consumption changes to income changes – mpc tells how much will be the change in consumption due a change in income.

Consumption Function • Consumption function will normally be like: • C = a+bY Where: C = Consumer spending a = Autonomous consumption. Y = Real disposable income . b = Marginal propensity to consume. or the level of consumption that would still exist even if income was zero.

•Keynes proposed that mpc declines as income rises. Mathematically: 1>dC/dY>0 .Consumption Function Y Consumption (C) N M C= f(Y) L 450 O Income (Y) X Keynesian Consumption Function •The curve LNM shows the marginal propensity to consume.

• Private Investment: Investments made by individuals and corporate • Public Investment: made by Government • Autonomous Investment is income inelastic. one year. • Gross investment is total value of productive assets created during a given period i.Investment Function • In the condition of equilibrium savings are equal to investment. is spent on investment. • Net investment in any given year = Gross investment minus an estimate for replacement investment. implying whatever is not spent on consumption. . etc. Some amount of investment which is normally done by the Government. increase in demand for capital goods. • Induced Investment takes place due to various factors such as higher expected rate of return.e.

• Marginal efficiency of capital of an asset depends upon the prospective yield and supply price of that asset. .Investment Function • In Keynesian theory inducement to invest depends upon two factors: (i) marginal efficiency of capital and (ii) the rate of interest. • Keynes defines marginal efficiency of capital as “being equal to that rate of discount which would make the present value of series of annuities given by the returns expected from the capital asset during its life just equal to its supply price”. • Marginal efficiency of capital (mec) represents the demand function of the capital goods (new investments). • Cost of capital is the supply price.

• Spending. • Hicks and Hansen add the effects of interest rate on spending and income.IS-LM Analysis • IS-LM model envisages two key markets: – the commodity (or goods) market and – the assets (or money) market. • Under equilibrium condition demand must be equal to supply. • According to Keynes. which is shown in the IS-LM model. . income and interest rate are jointly determined by equilibrium in the goods and money markets. and hence the dependence of assets markets on income. income affects spending. this in turn determines output and income.

planned investment falls. •With increase in rate of interest. which in turn results in a fall in national income (Y) IS2 and vice versa IS1. IS1 IS •Each point on the IS curve represents equilibrium in the commodity market at a given rate of interest. X O IS2 Aggregate Output/Income (Y) • This lowers aggregate expenditure (E).Commodity Market Equilibrium and IS Curve • There is inverse relationship between Y Rate of Interest (r) interest rate and planned investment. •The relationship between rate of interest and aggregate income or output (Y) is depicted by the IS curve. .

• Each point on the LM curve represents equilibrium in the money market. •An increase in aggregate output (Y) would lead to an increase in the demand for money. an increase in the demand for money would increase the equilibrium rate of interest and vice versa. • The upward sloping curve showing an equilibrium value of aggregate output (Y) for every value of r is known as the LM curve. • Hence for a given value of Y.Money Market Equilibrium and LM Curve Y Rate of Interest (r) LM2 LM LM1 O Aggregate Output/Income (Y) X • There is an equilibrium value of aggregate output (Y) for every value of r. . one can determine the equilibrium value of r in the money market.

Combining the Commodity Market and Money Market Y Rate of Interest (r) LM re E IS O Ye Aggregate Output/Income (Y) X • The point of intersection of the two curves is the equilibrium point (E) for both commodity market and money market. . • Thus re represents equilibrium rate of interest and Ye represents equilibrium aggregate income or output for both the markets.

thus leading to fall in the levels of both r and Y. . This would increase the levels of both r and Y to r1 and Y1 respectively.Effect of Shift in IS Curves Y Rate of Interest (r) r1 r r2 E1 LM E E2 IS IS2 Y2 Y Y1 IS1 O X Aggregate Output/Income (Y) • An increase in government expenditure (G) shifts the IS curve to the right. • The equilibrium would shift from E to E1. • Conversely a fall in the level of G would shift the IS curve to the left.

• A fall in the supply of money will result in a lower equilibrium value of Y and a higher level of r.Effect of Shift in LM Curves Y Rate of Interest (r) LM2 LM LM1 r1 r r2 E1 E E2 IS O Y1 Y Y2 X Aggregate Output/Income (Y) • An increase in supply of money would shift the LM curve to the right to LM1 . • An increase in the supply of money lowers the rate of interest and increases Y. . • This lowers the rate of interest from r to r1 and increases the level of aggregate output from Y to Y1.

In an open economy with four sectors. Aggregate supply refers to the supply of all goods and services in the economy for a given period of time.Summary • • • The circular flow of income shows the economic interdependence of consumers and sellers. (X-M). between whom this circular flow of production of goods and services. Saving is the withdrawal of money from the circular flow. where X represents exports and M represents imports. the national income is measured by aggregate expenditure that includes consumption expenditure. Sum of demand for all goods and services by all consumers for a given period of time may be termed as aggregate demand. income and expenditure takes place. government expenditure and net of exports. • • . while investment is the injection of money into the circular flow.

. This lowers the rate of interest and increases the level of aggregate output. This would increase the levels of both r and Y. An increase in supply of money would shift the LM curve to the right. The LM curve shows an equilibrium value of aggregate output (Y) for every value of r. An increase in G shifts the IS curve to the right.Summary • • • • • Marginal propensity to consume (mpc) is the ratio of consumption changes to income changes. The IS curve shows the combinations of interest rates and levels of output such that income equals planned expenditure. There is an equilibrium level of aggregate output (Y) for each value of rate of interest (r) in the market.