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INTRODUCTION TO

MACROECONOMICS
MODULE - I

FY.BBA SEMESTER II

Course Content

Module I - Introduction: concepts and variables of


macroeconomics, circular flow of income and expenditure.
Module II National income and its determination
National Income Aggregates, measurement of national
income.
Module III Classical Model of Income determination
Says Law, Output & Employment in the Classical Model,
Criticism of the Classical Model.
Module IV Keynesian Model of Income Determination
aggregate Demand in two, three and four sector
economy, determination of equilibrium income, shifts in
aggregate demand and the multiplier.

Course Content

Module V Analysis of the monetary sector :


Evolution and forms of money, functions of
money, theory of money supply, measures of
money supply in India, demand for money and
rate of interest.
Module VI IS-LM framework goods and money
market equilibrium, shifts in Is & LM curves, role
of monetary and fiscal policy, aggregate demand
- aggregate supply analysis.

Course Content

Module VII - Inflation & unemployment: Causes of


inflation, inflation & interest rates, economic and
social costs of inflation. Unemployment natural
rate of unemployment, frictional and structural
unemployment. Phillips curve, the trade off between
inflation and unemployment, sacrifice ratio.
Module VIII - Open economy: Foreign exchange
market, fixed & flexible exchange rate system,
balance of payment, Mundell Fleming with fixed &
flexible exchange rates, role of fiscal & Monetary
policy in an open economy

Reference books

Macroeconomics: Theory & Policy by Vanita


Agarwal
Macroeconomics by Dornbusch, Fischer
Macroeconomics by Mankiw, N Gregory
Macroeconomics by M.C. Vaish
The Macroeconomy today by Bradley. R.
Schiller

Macroeconomics??
Macroeconomics is the study of how the
national economy as a whole grows and the
changes occur over time. Thus it analyses the
big or the macro picture. It deals with
aggregates.

Scope & Importance of


Macroeconomics

Consumers, firms and governments take into


account economic conditions in making their
decisions. Macroeconomics involves study of
Economic Policies
Level of Unemployment
Price levels
Monetary Problems
Business Cycles
Trade performance
National Income & Economic Growth

Macroeconomic Policies

Fiscal Policy
Monetary Policy
Exchange Rate Policy
Trade Policy
Price and Income Policies

Basic Concepts in
Macroeconomics

Stock and Flow Concepts:


A stock variable is measured at a specific point
in time it signifies the level of a variable at a
point in time

Money supply, unemployment level and


foreign exchange reserves are examples
A flow variable is measured over a specific
period of time- it represents the change in the
level of a variable over a period of time
GDP, inflation, exports, imports, consumption
and investments are examples

Basic Concepts in
Macroeconomics

Equilibrium is state of balance or a state where


there is no change.
Partial and General Equilibrium:
Partial
equilibrium
analysis
involves
determination of equilibrium price and output
in each market, ceteris paribus.
General equilibrium approach involves a state
where all the markets and the decision making
units in the economy are in a simultaneous
equilibrium.

Circular Flow of National Income

It provides a macroeconomic framework used for


analyzing macroeconomic relationships.
It involves a process through which money and goods
move between the different sectors in the economy.
Firms are engaged in the task of production by
combining different factors of production (La,L,K,E).
Households are the owners (suppliers) of these factors
and thus receive factor payments.
This concept can be analyzed through different models.
Two sector with/ without savings, Three sector and Four
sector.

Circular flow of income in a Two Sector


Economy without savings

In a two sector economy there are only two sectors, households


and firms. There is no government intervention and there are no
international transactions i.e. no exports and imports making the
economy a closed economy.

Assumptions are as follows:


Households spend all their incomes on the purchase of goods
and services produced by the firms. In other words there are
no savings by the household sector.
Firms produce the goods demanded by the households. However
the production by the firms is just enough to satisfy the demand
by the households. In other words there are no inventories.
The firm distributes all that it earn from the sale of goods as
wages, interest, profit and rent. Thus there are no retained
earnings by the firms.

Circular flow of income in a Two Sector


Economy without savings
Services of Labor, Capital, Natural
Resources and Entrepreneurial Ability

Factor payments: Wages, Interest, Rent


& Profit

Households

Y=C
Consumption Expenditure for Goods
and Services

Flow of Goods and Services

Firms

Circular flow of income in a Two Sector


Economy without savings

Observations:
There two loops: Inner and Outer. The inner loop
represents money flow in the form of factor
payments and consumption spending and outer
loop represents physical flow in the form of
factor services and flow of goods and services.
There are two markets: Factor and Commodity
markets
Y= C

Circular flow of income in a Two Sector


Economy with savings and investment

In this two sector economy there are three sectors, namely


households, firms and financial system. There is no
government intervention and there are no international
transactions i.e. no exports and imports making the economy a
closed economy. This model takes into account savings by the
households and how it comes back in the economy in the form
of investment.
When households save, their expenditure on goods & services
decline to that extent and as a result money flow to the
business firms will contract. Factor payments such as wages to
workers will reduce and this will lead to the fall in total income
of the households. Thus savings reduce the money flow
and hence called a leakage in the circular flow.

Circular flow of income in a Two Sector


Economy with savings and investment

But savings need not lead to reduced aggregate spending


and income if they find their way back into flow of
expenditure. In any economy there exists set of financial
intermediaries such as banks, insurance companies, stock
markets where households park their savings. All these
intermediaries together are called financial system. It is
business firms that borrow from this system for investment in
capital goods such as machines, factories, tools and
instruments, trucks. Firms spend on investment in order to
expend their productive capacity in future. Thus, through
investment expenditure, savings of the households, are again
brought back into circular flow and thus investment is
called an injection in the circular flow which increases
the flow of money.

Circular flow of income in a Two Sector


Economy with savings and investment

Circular flow of money with saving and investment


is shown in the diagram where in the middle part a
box representing financial system is drawn. Money
flow of savings is shown from the households
towards financial system. Then flow of investment
expenditure is shown as borrowing by business
firms from the financial system.
Assumptions are as follows:
Households save in financial assets (productive)
only.
Households do not hold cash.

Circular flow of income in a Two Sector


Economy with savings and investment
Services of Labor, Capital, Natural
Resources and Entrepreneurial Ability

Factor payments: Wages, Interest, Rent


& Profit

Households

Savings (S)

Financial system

Y=C+S
Consumption Expenditure for Goods
and Services (C)

Flow of Goods and Services

Investment (I)

Firms

Circular flow of income in a Two Sector


Economy with savings and investment

Observations:
There are two flows: Money flow in the form of
factor payments and consumption spending and
Physical flow in the form of factor services and flow
of goods and services.
There are three markets: factor and commodity
and financial markets
There is a leakage in the form of saving which is
equal to injection in the form of investment
Y= C + S, Y = C + I

Circular flow of income in a Three


Sector Economy or a closed economy

This model includes transactions between the households, firms


and government making it more realistic. Government receives
revenue from taxes levied on the households and firms. Tax
payments reduce the disposable income of households and
firms which in turn reduce their expenditure and savings.
Thus T = TH + TF.
Government has to incur expenditure on many heads from tax
revenues. They include administration, justice, defense,
subsidies and so on. These expenditure can be divided under
four heads:
Payments made to the household sector for the services
rendered by them; for e.g. for those working in the armed
forces, civil services and others

Circular flow of income in a Three


Sector Economy or a closed economy

Payments made to the firms for the goods and services bought
from them
Subsidies given to the firms to encourage production in
certain sectors and areas in the economy.
Payments made for social security and welfare; these include
pensions, unemployment compensations and other transfer
payments.

G = GH + G F + G S + G T

In the circular flow of income in a three sector economy


money spent by the government is an injection which in turn
is received by households and firms. Thus leakages arise in
the form of saving and taxes which get injected in the
form of investment and government expenditure.

Circular flow of income in a Three Sector


Economy or a closed economy
Assumptions:

Taxes are the only form of revenue for the government

Four sectors namely households, firms, financial system & government

No international Transactions

Government has a balanced budget i.e. T = G

Observations:

There are two flows: Money flow in the form of factor payments and
consumption spending and Physical flow in the form of factor services
and flow of goods and services between households and firms. There
is an additional flow between government and the financial
system.

There are three markets: factor, commodity and financial markets

Y= C + S + T, Y = C + I + G, leakages are equal to injections.

Impact of government budget on


Circular flow of income

Government may follow a balanced, deficit or surplus budget.


In case of a balanced budget where government expenditure
is equal to government revenue or G = T, the amount of
income withdrawn from the circular flow as taxes re-enters
the flow as government expenditure.
In todays world government often follows deficit budget G >
T, This difference is financed by taking loans from the
financial sector. Such a budget implies net injections in the
economy and thus an expansion in the circular flow of
income.
In a surplus budget the government expenditure is less than
their revenue G < T. Such a budget implies net leakages and
thus a contraction in the circular flow of income.

Circular flow of income in a Three Sector


Economy
Government
Wages,
Salaries &
Transfer
Payments

Government
purchases of
goods
and services &
Subsidies

Services of Labor, Capital, Natural


Resources and Entrepreneurial Ability
Factor payments: Wages, Interest, Rent
& Profit

Households

Savings (S)

Financial system

Firms

Investment (I)

Y=C+I+G

Taxes

Consumption Expenditure for Goods


and Services (C)
Flow of Goods and Services

Government

Taxes

Circular flow of income in a Four Sector


Economy or an Open economy
Four sector economy is an open economy where it
deals with the rest of the world. Firms import goods
and services from foreign countries and households
receive payments for labour services. Households
spend on goods and services of foreign countries and
firms receive payment for the export of goods and
services to foreign countries. Both households and
firms will have net export (X-M) showing the balance
between receipts and payments involved. Taking the
net exports of both, magnitude of circular flow will be
more if X>M and will be less if X<M and will be
unaffected if X=M.

Circular flow of income in a Four Sector


Economy or an Open economy

Observations:
Equilibrium in all three sectors: S=I, X=M & G=T
S + T + M = I + G + X, leakages are equal to
injections.
Assumptions:
Only Households and firms deal with the rest of the world
Both the sectors have exports and imports
Five sectors namely households, firms, government,
foreign countries and financial system
Exports and imports of goods and services only,
excluding foreign investments and lending and borrowing.

Foreign Countries

Circular flow of income in a Four Sector


Economy
Government

Govt purchases
of goods
and services
& Subsidies

Payment for
imports

Wages, Salaries
& Transfer
Services of Labor, Capital, Natural
Payments

Payment for
Labor
services

Resources and Entrepreneurial Ability

Factor payments: Wages, Interest, Rent


& Profit

Households

Savings (S)

Financial system

Investment (I)

Firms

Y = C + I + G + (X-M)
Consumption Expenditure for Goods
and Services (C)
Taxes

Flow of Goods and Services


Expenditure on
imported
goods & Services

Government
Foreign Countries

Taxes
Payment for
exports

Circular flow of income in a Four Sector


Economy

When a country imports goods and services, the


expenditure incurred by the residents of the domestic
country leads to an increase in the income of the factors of
production of the country exporting the goods and services.
Hence imports lead to an outflow of income and
hence to a decrease in the circular flow of income.
When a country exports goods and services, the
expenditure incurred by the residents of the foreign country
leads to an increase in the income of the factors of
production in the domestic country which is exporting the
goods and services. Hence exports lead to an inflow of
income and thus an increase in the circular flow of
income.

Leakages and Injections in the


economy

Leakage is an income which is generated in the


production of the national output and which does not
become a par of the circular flow of income. There
are three types of Leakages: savings, taxes and
imports.
Injection is an amount of money which is spent by
different sectors in the economy and which is in
addition to their incomes generated in the circular flow
of income. Leakages and Injections in the
economy
In equilibrium leakages are equal to injections and the
size of circular flow remains the same.

Leakages and Injections in the


economy

If I > L, the circular flow will grow and economy will


proper.
If L >I, the circular flow will become smaller in size
and there is recession in the economy.
For household sector, leakages take the form of
savings, personal income tax, sales tax and imports
whereas injections include government expenditure.
For firms leakages take the form of corporation tax,
business taxes and business savings, imports
whereas injections include government expenditure,
investment expenditure and export of goods and
services.

Importance of Circular Flow of


Income

Helps in understanding smooth functioning of the economy

Helps to know the problem of disequilibrium and guides in


restoration of equilibrium

Helps to find out leakages in the circular flow in the form of savings,
taxes and imports and their effects on income and expenditure

Highlights the importance of monetary & fiscal policies to bring


about equality between income and expenditure

Helps to understand a typical pattern : Production creates income,


income creates spending and spending induces production. Thus
there are three ways by which size of circular flow can be measured:
At the production stage by the value of output, at the income stage
by the amount of factor incomes earned and at the spending stage
by the amount of total expenditure in the economy. So all the three
can be used for measuring national income of an economy

Thank You