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BY

Qazi Subhan
M. Phil (Eco), Pak
LLM (IPR), Italy

Weeks 15
Monetary and Fiscal Policy
and structure of economy

Weeks 14
Demand Management Policies

Week 16
Inflation and Unemployment
and their measurement

Weeks 13
Concept of Multiplier
Week 17
Project Presentations
Weeks 12
Consumption and Saving
Functions

Macro
Economics
Week18

Weeks 11
National Income
Determination

Qazi Subhan

Final Exam
Weeks 10
Introduction to Macro
economics
Bahria University

Department of Management Sciences

Fall 2014

1.
2.
3.

4.
5.
6.

Introduction to Macroeconomics
National Income Determination
Derivation of Aggregate Demand,
Aggregate Supply and General Equilibrium
Demand Management Policies
Inflation and Unemployment
Measurement of Inflation with price Indices.

Definition of Economics

Classification of Economics

What is Macroeconomics

Goals of Macro Economics

Major Issues addressed by Macro Eco

The study of aggregate measures of the


economy in any country.

OR

The study of all those issues which have an


impact on the economy as a whole like
inflation, unemployment, trade and other key
social variables

The Great Depression was a


period of severe economic
contraction and high
unemployment that began in
1929 and continued throughout
the 1930s.

Classical economists applied microeconomic


models, or market clearing models, to
economy-wide problems.
However, simple classical models failed to
explain the prolonged existence of high
unemployment during the Great Depression.
This provided the momentum for the
development of macroeconomics.

In 1936, John Maynard Keynes published The

General Theory of Employment, Interest, and


Money.

Keynes believed governments could intervene


in the economy and affect the level of output
and employment.
During periods of low private demand, the
government can stimulate aggregate demand
to lift the economy out of recession.

Sustainable Economic Growth

Price Stability ( To Control Inflation)

Employment Opportunities

Economic Indicators

Social Indicators

GDP

Health

Growth
GNP Growth
Employment
Inflation
Exports
Imports
BOP
BOT
Trade Deficits

situation
Literacy Rate
Transportation
Communication
Soft Drinking Water
Poverty
Sanitation
Infrastructure

Definition
Types

of National Income

of GNP

Measurement

of GNP

Expenditure Approach
Two Sector Model
Three Sector Model
Four Sector Model

Income Approach

Two Sector Model


Three Sector Model
Four Sector Model

Circular Flow of National Income

National Income of a country can be


represented either by GDP or GNP
GNP (Gross National Product)
The value of all goods and services which has
been produced by one nation in a specified
time period (One Year) is called GNP.
GDP ( Gross Domestic Product)
The value of all goods and services which has
been produced with in the boundaries of a
country in a specified time period (One Year)
GNP = GDP+ Foreign Remittances (earnings)

Nominal GNP (based on Current Prices)

Real GNP (Based on Base Year price)

Potential GNP

Actual GNP

EXPENDITURE APPROACH
The national income can be measured through
the aggregation of all the expenditures of the
economy like the expenditures for the
development of the country.
This approach can be interpreted through the
following models
TWO SECTOR MODEL
Y= C + I
THREE SECTOR MODEL
Y=C+I+G
FOUR SECTOR MODEL
Y = C + I + G + (X-M)

INCOME APPROACH
TWO SECTOR MODEL
Y= C + S
THREE SECTOR MODEL
Y=C+S+T
FOUR SECTOR MODEL
Y = C + S + T + Rf

C+S+T+ Rf
C+I+G+(X-M)
E2

E1

E0

C+I+G
C+I

Income

Resources
Business
Firms

Households
Goods
Expenditures

Solid Lines - Flow of Money


Dashed lines - Flow of Goods and Services

Everyones
expenditure is
someone elses
receipt. Every
transaction
must have two
sides.

Multiplier means any numeric number which


shows a change in dependent variable due to
one unit change in Independent variable. For
example how much change is required in
consumption to increase 400 million in GNP.
It is based on consumption Multiplier.

Multiplier means a change in autonomous


expenditures (e.g. investment) leads to an even
larger change in aggregate income (GNP).
An

increase in spending by one party


increases the income of others. Thus,
growth in spending can expand output by a
multiple of the original increase.
The multiplier is the number by which the
initial change in spending is multiplied to
obtain the total amplified increase in
National income.
The size of the multiplier increases with the
marginal propensity to consume (MPC).

Significance of Multiplier
In

evaluating the importance of the


multiplier, one should remember:
taxes and spending on imports will
dampen the size of the multiplier;
it takes time for the multiplier to work;
and,
the amplified effect on real output will
be valid only when the additional
spending brings idle resources into
production without price changes.

The Multiplier Principle


Expenditure
stage

Additional income

Additional consumption

Marginal propensity
to consume

(dollars)

(dollars)

Round 1
Round 2
Round 3
Round 4
Round 5
All others

1,000,000
750,000
562,500
421,875
316,406
949,219

750,000
562,500

3/4
3/4

421,875
316,406
237,305
711,914

3/4
3/4
3/4
3/4

Total

4,000,000

3,000,000

3/4

For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.

The multiplier concept is fundamentally based upon


the proportion of additional income that households
choose to spend on consumption: the marginal propensity
to consume (here assumed to be 75% = 3/4).
Here, a $1,000,000 injection is spent, received as
payment, saved and spent, received as payment,
saved and spent etc. until effectively, $4 million
is spent in the economy.

A Higher MPC Means a Larger Multiplier


MPC

Size of
multiplier

9/10
4/5
3/4
2/3
1/2
1/3

10.0
5.0
4.0
3.0
2.0
1.5

As the MPC increases more and more money of every


injection is spent (and so received as payment and
then spent again, received as payment and spent
again, etc.).
The effect is that for higher MPCs, higher multipliers
result, specifically the relationship follows this
1
equation:
M

1 MPC

Consumption Multiplier

Investment Multiplier

Government Multiplier

Tax Multiplier
Lump sum Tax Multiplier
Income Tax Multiplier

(Expenditure Multipliers)
Consumption Multiplier
Investment Multiplier
Government Multiplier
K = 1/1- MPC

Tax Multiplier
Lump sum tax Multiplier: -MPC/1-MPC
Income tax Multiplier (K)=
-MPC/1-MPC+MPC * Tax Rate

Y C I G
where
C C0 c1Y
I I 0 , G G0
Then
1.

find equilibrium output (Y*), consumption level and savings


of a country.

2. Find Investment multiplier and consumption multiplier

Y C I G
where
C C0 c1 Y T
T T0 , I I 0 , G G0
Then
1. find equilibrium output (Y*), consumption level and savings of
a country.
2. Find Investment multiplier, consumption multiplier and Tax
Multiplier

Y C I G
where
C C0 c1 Y T
T T0 tY , I I 0 , G G0
Then
1.
2.

Find equilibrium output (Y*), consumption level and savings


of a
country.
Find Investment multiplier, consumption multiplier and
Income Tax Multiplier

Suppose

Practice Question

C 200 0.67(Y T )
T 130 0.3Y
I 150
G 340
( X M ) 100

Then
1.
Find equilibrium output, level of consumption
and saving from the above information
2.

3.

Find Income Tax Multiplier, lump sum tax and


Expenditure Multiplier.
Suppose Government has imposed tax by 15%
on Output then what would be the effect on
equilibrium output, consumption and savings.

Y C I G
where
C 100 0.65Y T
T 240 0.15Y , I 1000, G 500
Then
1.

2.

Find equilibrium output (Y*), consumption level and


savings of a country.
Find Investment multiplier, consumption multiplier
and Income Tax Multiplier

To capture the concept of Aggregate


demand, following markets should be
discussed

Product Market

Money Market

Labor Market

From product market, IS Curve is derived


and from money market LM Curve is derived
With the intersection of IS and LM,
Aggregate Demand would be determined
From Labor Market, we can derive
Aggregate Supply
At That point where Aggregate Demand
and
Aggregate
Supply
are
making
intersection,
that
is
the
point
of
determination for GENERAL EQUILIBRIUM for
the economy which shows the relationship
between General Price Level and GNP or
National Income

Product Market

Money Market

Both Curves are showing relationships between rate of interest and national income

IS Curve

LM Curve

With the intersection of IS-LM, Aggregate Demand would be determined

In IS (-tive b/w r&Y

In LM (+tive b/w r&Y

That market in which the goods are transacted


at a certain price. Technically
Y = C + I + G +X-M is considered as goods
Market because in all the components of
aggregate expenditure, goods are involved. So
any change in the components would cause a
change in Aggregate Demand.
From Product Market, we can derive IS
(Investment Saving) Curve for the derivation of
Aggregate Demand.

That market which is concerned with money.


Two market forces ;Money Demand and
Money supply are involved for the
determination of rate of interest and quantity
of money
From the money Market, we can derive LM
(Liquidity of money) Curve for derivation of
Aggregate Demand.

In labor market, we have two market forces


Labor Demand
Labor Supply
With intersection of labor demand and labor
supply, wage and employment level has been
determined
Aggregate supply is determined with the help
of labor market and production function (Q = f
(K, L)

IS (Investment Saving) curve shows negative


relation between rate of interest and national
income.
According to this approach, as rate of interest
increases, Investment would come down. As
Investment decreases, total national income
would come down.

Consumption

Government Expenditure

Exports

Imports

Taxes

Money market consists of two market forces


Money Demand
Money supply
Money Demand
The people are demanding money for three purposes
Money Demand for daily Transactions
Money Demand for Precaution
Money Demand for Speculation

Money supply is defined as M1, M2 and M3


M1= Currency + Demand Deposits

M2=M1+Money market mutual funds +


Time Deposits + Postal Deposits
M3= M2-Postal deposits
Normally, Money Supply is in the hand of central
bank so it is generally kept fixed in the analysis.

Liquidity of Money (LM) curve can be derived


from money market.
As national income increases, the people are
demanding more money for speculation and
ultimately the rate of interest will increase.
LM curve shows positive relation between rate
of interest with the national income

With the intersection of product and money


market or (with IS and LM), Agg. Demand
would be determined.
Aggregate demand shows negative relation
between price and national income.

An increase in
P
the price level
causes a fall in
real money
balances (M/P ),
causing a
decrease in the
demand for
goods &
services.

AD

Consumption

Government Expenditure

Exports

Imports

Taxes

Money Supply

An increase in
the money
supply shifts the
AD curve to the
right.

AD2
AD1

In labor market, wages and employment level


has been determined with the help of two
market forces
Labor Demand

Labor Supply
Labor Demand
Labor demand has negative relation with wage
because as wage increases, cost of production
would increase. As cost of production
increases, it implies that the firm would
reduce the demand for labor. Briefly, there is
reciprocal relation between wage and labor
demand

Labor supply has positive relation with wage.


As wage increases, the incentives for the
labor would increase and the people are
willing to offer more services at high wage
rate to any organization.

Aggregate Supply can be derived from labor


market and production function.
As employment increases, output will
amplify. An increase in output will cause to
increase in GNP because GNP is the value of
total product which has been produced by
one nation in a specified time period.
The labor market is related to aggregate
supply through production function.

Labor Supply

Labor Demand

Production Techniques
Labor Intensive technology
Capital Intensive Technology
Neutral Technology

Fiscal Policy

Monetary Policy

Exchange Rate Policy

Definition

Objectives of Fiscal policy

Tools of Fiscal Policy

Kinds of Fiscal Policy

Application of tools of fiscal policy to


Economic situation.

Fiscal Policy means that policy which is


formulated by the government to achieve its
objectives with the help of its tools.

Objectives
Economic Growth
Price stability
Employment Opportunities

Government Expenditure
Taxes
Direct Tax
Indirect Tax

Contractionary Fiscal Policy (Tax and G )


Expansionary Fiscal Policy (G and Tax )

Business Cycles

To Product Market

To Money Market

To Labor Market

Definition

Objectives of Monetary policy

Tools of Monetary Policy

Kinds of Monetary Policy

Application of tools of Monetary policy to


Economic situation.

Definition
Monetary Policy is designed by State Bank to
stabilize the economy with the monetary
tools
Objectives

To improve the economic growth

To stabilize the prices

To increase employment opportunities

Bank Rate

Required Reserve Ratio (RRR)

Open Market Operation (OMO)

There are two types


Expansionary Monetary Policy
Bank Rate decrease
RRR decrease
Purchase of Public shares

Contractionary Monetary Policy


Bank Rate Increase
RRR Increase
Sale of Public shares

Money Market

Product Market

Labor Market

Business Cycle