Module 6

MACROECONOMICS
Macroeconomics

 Macroeconomics is the study of economy as a

whole.

 It focuses on the determinants and dynamics of

aggregate variables over time: unemployment,

aggregate level of prices, and real economic

activity
 To evaluate the economy’s performance, economists focus on the
following aggregate variables:

 Real Gross Domestic Product (GDP)—the value of all final goods

and services produced within an economy in a pre-specified period of
time (usually measured quarterly and annually) expressed in fixed
prices. It also measures the total economy’s income, and expenditures
of foreign and domestic households on domestic goods and services.

 GDP is the Market Value of all Final Goods and Services Newly Produce
d on Domestic Soil During a Given Time Period (different than GNP)
 Production Method: Measure the Value Added summed
across all firms (value added firms (value added = sale price -
cost of raw sale price - cost of raw materials)
 Income Method : Labor Income (wages/salary) + Labor
Income (wages/salary) + Capital Income (rent, interest,
dividends, profits)+ Government Income (taxes)
 Expenditure Method: Spending by consumers (C) +
Spending by businesses (I) + Spending by government (G) +
Net Spending by foreign sector (NX)
 Inflation rate — measures how quickly prices change in
the economy.

 Unemployment rate — measures the fraction of

unemployed in the total labor force.
 Aggregate variables tend to co-move over time
Economy in long run
 If an economy is said to be in long-run equilibrium,
then Real GDP is at its potential output, the actual
unemployment rate will equal the natural rate of
unemployment (about 6%), and the actual price level will
equal the anticipated price level.
 BUSINESS CYCLES
 Fluctuations in macroeconomic variables are known as business
cycles.

 Macroeconomic variables : consumption, investment, employment,

output, etc.
 Since GNP is the comprehensive measure of the overall economic
activity, we refer to business cycles as the short term cyclical
movements in GNP.
 In the words of Keynes : “A trade cycle is composed of periods of
good trade characterised by rising prices and low unemployment
percentages, alternating with periods of bad trade characterised by
falling prices and high unemployment percentages.”
 a business cycle is the periodic but irregular up-and-down
movements in economic activity. Since their timing
changes rather unpredictably, business cycles are not
regular or repeating cycles like the phases of the moon.
 Characteristics

 Industrialized capitalistic economies witness cyclical movements in

economic activities. A socialist economy is free from such disturbances.

 It exhibits a wave-like movement having a regularity and recognized

patterns.That is to say, it is repetitive in character.

 Almost all sectors of the economy are affected by the cyclical

movements. Most of the sectors move together in the same direction.

During prosperity, most of the sectors or industries experience an

increase in output and during recession they experience a fall in output.

 Not all the industries are affected uniformly. Some are hit
badly during depression while others are not affected
seriously.
 Investment goods industries fluctuate more than the consumer
goods industries. Further, industries producing consumer durable
goods generally experience greater fluctuations than sectors
producing nondurable goods. Further, fluctuations in the service
sector are insignificant in comparison with both capital goods and
consumer goods industries.
 One also observes the tendency for consumer goods output
to lead investment goods output in the cycle. During recovery,
increase in output of consumer goods usually precedes that of
investment goods. Thus, the recovery of consumer goods
industries from recessionary tendencies is quicker than that of
investment goods industries.
 Just as outputs move together in the same direction, so do the
prices of various goods and services, though prices lag behind
output. Fluctuations in the prices of agricultural products are
more marked than those of prices of manufactured articles.
 Profits tend to be highly variable and pro-cyclical. Usually,
profits decline in recession and rise in boom. On the other
hand, wages are more or less sticky though they tend to
rise during boom.

 Trade cycles are ‘international’ in character in the sense

that fluctuations in one country get transmitted to other
countries. This is because, in this age of globalisation,
dependence of one country on other countries is great.
 Periodicity of a trade cycle is not uniform, though
fluctuations are something in the range of five to ten
years from peak to peak. Every cycle exhibits similarities
in its nature and direction though no two cycles are
exactly the same. In the words of Samuelson: “No two
business cycles are quite the same. Yet they have much in
common. Though not identical twins, they are
recognisable as belonging to the same family.”
Phases Of Business Cycles

 Haberler in his work on business cycles has named

the four phases of business cycles as:

 (1) Upswing,

 (2) Upper turning point,

 (3) Downswing, and

 (4) Lower turning point.

 Expansion (Boom, Upswing or Prosperity)

 Peak (upper turning point)

 Contraction (Downswing, Recession or Depression)

 Trough (lower turning point)

Causes of Business Cycle
 Natural Factors
 Wars
 Political Factors
 Supply of Money
 Future Expectation
 Population Explosion
 International Factors
 Economic Policies
 Reduction in Credit
Income
 Income are of two type domestic income and national income

 Domestic income when we count the income generated

within the geographical boundary of the country. the income
earned in India during the year by citizens and non
citizen/foreign country members.

 National income when we count the income generated by

Indians either working in India or in any other country i.e.,
income earned by Indians in India and in other countries
National Income
 National Income is the total value of all final goods and
services produced by the country in certain year. The
growth of National Income helps to know the progress of
the country.
 According to Marshall: “The labour and capital of a
country acting on its natural resources produce annually a
certain net aggregate of commodities, material and
immaterial including services of all kinds. This is the true
net annual income or revenue of the country or national
dividend.”
 In the words of Pigou, “National income is that part of
objective income of the community, including of course
income derived from abroad which can be measured in
money.”
 According to Fisher, “The National dividend or income
consists solely of services as received by ultimate
consumers, whether from their material or from the
human environments. Thus, a piano, or an overcoat made
for me this year is not a part of this year’s income, but an
addition to the capital. Only the services rendered to me
during this year by these things are income.”
 From the modern point of view, Simon Kuznets has
defined national income as “the net output of
commodities and services flowing during the year from
the country’s productive system in the hands of the
ultimate consumers.”
assumptions of estimating of income of a
country
 Only value of monetary transactions are counted in the
national income.
 Only legal activities are counted in national income.
corruption is not involved, national income is a very
rough estimation it cannot be used as yardstick.
 Only income generated through production process is
counted in national income. Ex. capital gain is not treated
as income it is just a transfer of income.
 Money characteristics
 Medium of exchange :The medium of exchange means that it
makes transactions easier to conduct. So, in the absence of money, we
might have to barter for goods and services. This would be a problem
for me as an economic educator. If I wanted my transmission fixed on
my car, I would have to find a mechanic who would exchange his
transmission repair services for a lesson on aggregate supply and
aggregate demand. In the absence of a barter economy, we use money
as our medium of exchange.
 Store of value
 measure of value
Money supply
 Money supply is the amount of money in circulation in the
economy at any point of time. It not only includes the currency
& coins in circulation, but it also includes demand & time
deposits of banks, post office deposits and such related
instruments. Valuation and analysis of the money supply helps
the economist and policy makers to frame the policy or to
alter the existing policy of increasing or reducing the supply of
money. The understanding of money supply is important as it
ultimately affects the business cycle and thereby affects the
economy.
 M0 (Reserve Money): Currency in circulation +
Bankers’ deposits with the RBI + ‘Other’ deposits with
the RBI = Net RBI credit to the Government + RBI credit
to the commercial sector + RBI’s claims on banks + RBI’s
net foreign assets + Government’s currency liabilities to
the public – RBI’s net non-monetary liabilities.
M1

M1 includes Excludes

1.Currency with public

2.Demand deposit in all banks •India’s deposits with IMF, World
(e.g. current account, savings bank, Foreign Government etc.
account) •Interbank deposits
3.Other deposits with RBI
M2

 M2= M1 + Post office bank savings*

*Similar to regular banks, Post office also

offers their time savings account, recurring
deposit account, time deposit account. Here we
count the Post office savings (= “DEMAND
deposit” type) only.
 M3 (Broad Money)

 also called Money aggregate

 M3 = M1 + Time deposits with commercial banks (Fixed deposits,

Recurring deposits). Net bank credit to the Government + Bank credit
to the commercial sector + Net foreign exchange assets of the banking
sector + Government’s currency liabilities to the public – Net non-
monetary liabilities of the banking sector (Other than Time Deposits).

 M4

 M4= M3 + total post office deposits.*

*meaning those Post Office “time deposits” and “recurring deposits”

also. But excludes national savings certificate etc.
Liquidity and ranking

NAME TYPE LIQUIDITY*

M1 Narrow money highest

M2 Narrow money less than M1

M3 Broad money less than M2

M4 Broad money lowest liquidity

Inflation
 Define as a sustained increase in the average price level of all
goods and services produced in the economy. There are a
couple of key terms there. One of them is “average price level.”
So, for instance, when the price of gas goes up and down, or the
price of milk goes up and down, it doesn’t necessarily mean
there’s inflation, because inflation is a basket—it’s the average
price level. So, instead of looking at the prices of individual
goods, when we look at inflation, we look at the price level of
that entire basket of goods that are in the measure.
So what causes inflation?
 Inflation is caused when the money supply in an economy
grows at faster rate than the economy’s ability to produce
goods and services. In our auction economy the
production of goods and services was unchanged, but the
money supply grew from round one to round two.
Because the money supply grew, and the output of goods
and services did not grow, our economy experienced
inflation.
 M define as the supply of money in the economy.
 V is velocity of money.
 P is the overall price level.
 Q is the quantity of goods and services produced, also known
as output.
MV = PQ

 MV represents the total amount spent by buyers, and PQ

represents the total amount received by sellers.
 To summarize, the money supply is important because if
the money supply grows at a faster rate than the
economy’s ability to produce goods and services, then
inflation will result. Also, a money supply that does not
grow fast enough can lead to decreases in production,
leading to increases in unemployment.
Open Economy
 An open economy is an economy in which there
are economic activities between the domestic
community and outside. People and even
businesses can trade in goods and services with
other people and businesses in the international
community, and funds can flow as investments
across the border.
 An Open Economy Differs from Closed Economy by

 Spending need not equal output

 Saving need not equal investment

 Open economy measurement: net exports, balance of

payments and national accounting identities

Unemployment
 Unemployment is defined as a situation where someone
of working age is not able to get a job but would like to
be in full-time employment.

 Note: If a mother left work to bring up a child or if

someone went into higher education, they are not
working but would not be classed as unemployed as they
are not actively seeking employment.
 Unemployment is a phenomenon that occurs when a person who
is actively searching for employment is unable to find work.

 Unemployment is often used as a measure of the health of the

economy.

 The most frequently measure of unemployment is the

unemployment rate, which is the number of unemployed people
divided by the number of people in the labor force.
Types of Unemployment

 Frictional Unemployment

 Structural Unemployment

 Seasonal Unemployment

 Cyclical Unemployment
 Frictional Unemployment is associated with a dynamic labor force
in a stable economy with imperfect information about available jobs.
People are just entering the labor force or moving between careers
and locations (dynamic labor force) and while there are job
openings (stable economy) it takes time to find a new job (imperfect
information). We should expect with the Internet as a growing new
source of job information that job search time and frictional
unemployment should decline. However, the process of applying and
interviewing for a new job remains costly in terms of time required.
 Structural Unemployment is associated with a stable
labor force in a dynamic economy. There may exist a
mismatch between workers' skills and the skills required
for available jobs. For example, as technology progresses
new industries arise and mature ones decline. Badly
managed firms go bankrupt and new firms are formed.
Structural unemployment results when the location
and/or skills of the labor force do not match the available
jobs. It takes time for displaced workers in one region of
the country to find comparable work elsewhere, or
receive retraining for the skills required with different or
new technologies.
 Seasonal unemployment is associated with the seasons
of the year. Some businesses and industries experience a
peak in consumer demand during the last half of the year
leading up to Christmas. Snow skiing and Florida beach
resorts are busiest during the winter. Many other resorts
have customers only during the summer.
 Cyclical unemployment comes around due to the business
cycle itself. Cyclical unemployment rises during recessionary
periods and declines during periods of economic growth. For
example, the number of weekly jobless claims in the United
States has slowed in the month of June, as oil prices begin to
rise and the economy starts to stabilize, adding jobs to the
market.
Causes of Unemployment

 Inflation
 Disability
 Recessions
 Rapid changes in technology
 Attitude towards employers
 Perception of employees
 Employee values
 Discriminating Factors like ethnicity, race, age etc. in
work place