MACRO

ECONOMICS
 Module 1: Syllabus

Introduction to Macroeconomics and National Income Accounting

Basic issues studied in macroeconomics; basics of GDP, GNP, NDP & NNP,
measurement of gross domestic product; income, expenditure and the circular
flow of money; national income
accounting for an open economy.

Money
Functions of money; quantity theory of money; determination of money supply
and demand; credit creation; tools of monetary policy. , interrelationship between
monetary policy and fiscal policy.

Inflation, Unemployment and Expectations

Inflation and its social costs; hyperinflation. price indices,
Phillips curve; adaptive and rational expectations; policy ineffectiveness debate.
 Text Books & Reference books

Text Books:
• N. Gregory Mankiw. Macroeconomics, Worth Publishers, 7th edition, 2010.
https://amzn.in/d/cYWwPmQ
• Dornbusch, Fischer and Startz, Macroeconomics, McGraw Hill, 11th edition, 2010.
https://amzn.in/d/1Gojop6
Reference Book:
• Olivier Blanchard, Macroeconomics, Pearson Education, Inc., 5th edition, 2009.
• Richard T. Froyen, Macroeconomics, Pearson Education Asia, 2nd edition, 2005.
 Meaning of Macroeconomics….

• Macro economics deals with total or aggregate level of output, aggregate level
of consumption, aggregate level of investment, aggregate level of
employment and general price level in economy.

• Macroeconomics (from the Greek prefix makro- meaning "large" and

economics) is a branch of economics dealing with the performance, structure,
behavior, and decision- making of an economy as a whole, rather than
individual markets. This includes national, regional, and global economies.
 Macroeconomic Concerns….

• Three of the major concerns of macroeconomics are:

– National Income

– Inflation

– Unemployment
 National Income and Growth

• Growth refers to change in the level of economic activity from one year to

another year.

• Growth means that poor and developing countries wish to attain a rise in their

national income and per capita income.

• Aggregate output is the total quantity of goods and services produced in an

economy in a given period.

• The aggregate output is the main measure to see how well an economy is doing.
 Unemployment

• Unemployment refers to the situation where the population of a country do

not find work to earn their livelihood.
• Unemployment represents that ratio of labor force which fails to get
employment.

• The currently 7.8% of Indian population is unemployed (As on September 2024)

• The unemployment rate is a key indicator of the economy’s health. The
existence of unemployment seems to imply that the aggregate labor market is
not in equilibrium.
 Inflation

• Inflation is an increase in the overall price level.

• Hyperinflation is a period of very rapid increases in the overall price level.
Hyperinflation is a rare phenomenon.
• Deflation is a decrease in the overall price level. Prolonged periods of deflation can be
just as damaging for the economy as sustained inflation.
Problem of Unemployment:
• During 1930 the phenomena of unemployment got a lot of attractions. Policy makers
presented their ideas to remove unemployment .
• So Government tried to provide better social and economic service dueto which
Government expenditures went on increasing.
 Scope of Macroeconomics

Scope of
macro
economics

Theory of Theory of Theory of

Theory of Theory of
national general price economic
employment money
income level growth
 Scope of Macroeconomics

(i) In National Income: The study of macroeconomics is very important for evaluating the
overall performance of the economy in terms of national income. With the advent of the
Great Depression of the 1930s, it became necessary to analyze the causes of general
overproduction and general unemployment.
(ii) In Economic Growth: The economics of growth is also a study in macroeconomics. It is
on the basis of macroeconomics that the resources and capabilities of an economy are
evaluated. Plans for the overall increase in national income, output, and employment are
framed and implemented so as to raise the level of economic development of the
economy as a whole.
 Scope of Macroeconomics

(iii) In Monetary Problems:

It is in terms of macroeconomics that monetary problems can be analysed and

understood properly. Frequent changes in the value of money, inflation or deflation,
affect the economy adversely. They can be counteracted by adopting monetary, fiscal
and direct control measures for the economy as a whole.
(iv) In Business Cycles:

Further macroeconomics as an approach to economic problems started after the

Great Depression. Thus its importance lies in analyzing the causes of economic
fluctuations and in providing remedies.
 Scope of Macroeconomics

(iii) In Monetary Problems:

It is in terms of macroeconomics that monetary problems can be analysed and

understood properly. Frequent changes in the value of money, inflation or deflation,
affect the economy adversely. They can be counteracted by adopting monetary, fiscal
and direct control measures for the economy as a whole.
(iv) In Business Cycles:

Further macroeconomics as an approach to economic problems started after the

Great Depression. Thus its importance lies in analyzing the causes of economic
fluctuations and in providing remedies.
 Macroeconomics Variables

AGGREGATE DEMAND AND AGGREGATE SUPPLY

Aggregate demand is the total demand in terms of goods and assets at a given
price by all the people in an economy.
Aggregate demand consists of two components, aggregate demand (AD) for
consumer goods (C) and aggregate demand for capital goods (I). Thus we can
write the above equation as:
AD = C + I
Aggregate supply is the total national output produced and supplied by all the
factors of production in an economy.
Aggregate supply consists of supply of consumer goods and capital goods.

AS = C + I
 Stocks and Flows

Stock may be defined as any economic variable which has been accumulated at a
specific point of time, like money, assets and wealth.

Flow includes the variables which increases (inflows) and decreases (outflows) the
stock, like income, consumption, saving and investment over a period of time.

STOCK INFLOW OUTFLOW

INVENTORY INCOMING GOODS OUGOING GOODS
BANK BALANCE DEPOSITS WITHDRAWALS
POPULATION BIRTH + IMMIGRATION DEATH + EMIGRATION
 INTERMEDIATE AND FINAL GOODS

Intermediate goods (and services) are items purchased by firms for using them in
production of some other goods of utility.

Final goods are demanded by the final consumer for using these goods as they are.
 GOVERNMENT EXPENDITURE AND REVENUE

Government expenditure refers to outlay on national defense, road building and

maintenance, railways, national health, and free education and salary of government
employees.

All government current expenditure is included in national output.

There is another type of expenditure, known as transfer payments, which refers to
payments made to certain sections of society as a social welfare measure. It is an
exchange of purchasing power from one group of people to another.

These include unemployment compensation, retirement pension, etc.

Since the receiver of such payments (such as old, unemployed, handicapped and
needy families) do not contribute to national output therefore such payments are
referred to as transfer payments and they are not treated as a part of the
government’s current output of goods and services.
 CIRCULAR FLOW OF
ECONOMIC ACTIVITIES AND
INCOME – TWO SECTOR
ECONOMY
 What is Circular Flow of Income ?

• It is the flow of money income or the flow of goods and services

across different sectors of an economy in a circular form.

• The circular flow of income shows the connection or linkages

between different sectors of the economy.
• It can be explained with the help of economic models.
• The circular flow model is a picture of market economy in action. It
tells how the money flows in the economy.
 Types of Circular Flow Models

 Two sector model

 Three sector model

 Four sector model

 TWO SECTOR ECONOMY

It consists of household sector and the industrial sector.

• Household sector demand goods and services and they provide labour resources to

the business sector.

• Industrial sector produce and supply goods and services to the household sector

Businesses demand resources for production: land, labour, capital, and

entrepreneurs.
 Two Sector Economy Model

Household sector

Spending
Products

Factor Incomes Factor Services

Labour
Wages/Salaries
Interest
Capital
Profit Entrepreneur
Rent Land

Firms/ industrial sector

 Three Sector Economy

It is called the closed economy model.

It includes the

• household sector

• industrial sector

• government sector – the government collects taxes to provide resources and

services to the people

 Three Sector Economy

Product
Product
goods & services… Markets ….goods & services
Markets

….consumption spending….

industrial sector
Household sector
Government sector
….salaries, wages, rent, dividends…..
Factor
Factor
land, labor, capital…… Markets
Markets
 CIRCULAR FLOW OF
ECONOMIC ACTIVITIES
AND INCOME – FOUR
SECTOR ECONOMY
 CIRCULAR FLOW OF ECONOMIC ACTIVITY AND INCOME – FOUR SECTOR ECONOMY

GOVERNMEN
T Taxes
Taxes Remittance for
Salaries Factor Payment purchases or
Subsidiaries
Factor Inputs
HOUSEHOLD Financial FIRMS
S Savings Market Investments
Consumption
Expenditure Goods &
Services
Exports FOREIGN
Exports
Imports NATION Imports
 Difference between
Leakages and Injection
 Difference between leakages and Injections

Leakages Injections
• These flow variables have a negative • These cause positive impact on the
impact on the process of production process of production or income
( or the process of income generation). generation.

• These are withdrawals from circular • These are additions to the circular flow
flow of income. of income.
Effect on economy : Leakages Effect on economy : Injections
• Reduce flow of income/production • Add to production capacity of the
• Reduce demand of goods and services economy.
• Generate demand of goods and
services.

• Examples: Saving, taxation and • Examples: investments, exports,

imports, etc. consumption expenditure, etc.
 Uses of Circular Flow of Income

• It gives the clear picture of the market economy.

• It helps in the calculation of national income.

• Formulation of trade policies which promotes the exports and reduces the imports.

• It explains the importance of monetary policy by establishing equilibrium between

savings and investment.

Concept of National
Income
 National Income

“National income or product is the final figure you arrive at when you apply the
measuring rod of money to the diverse apples, oranges, battleship and machines
that any society produces with its land, labor and capital resources.”

- Paul A. Samuelson

National Income National Income Committee of India 1951 defines National Income
as follows: “ A national income estimate measures the volume of commodities and
services turned out during a given period counted without duplication.
 Components of National Income

 Gross Domestic Product (GDP)

• GDP at factor cost
• GDP at market price
 Gross National Product (GNP)
 Net Domestic Product (NDP)
 Net National Product (NNP)
 Per capita income
 Per capita disposable income
 CONCEPT OF –
GDP, GNP, NDP, NNP
 GROSS DOMESTIC PRODUCT (GDP)

GDP is the sum of money values of all final goods and services produced within the
domestic territories of a country during an accounting year.

It includes income from exports and payments made on imports during the year.
However, it does not include the earning of nationals working abroad as also of the
foreign nationals working in our country.
 GROSS DOMESTIC PRODUCT (GDP): Real V/s Nominal GDP

In order to deal with the ambiguity inherent in the growth rate of GDP, macroeconomists have created
two different types of GDP, nominal GDP and real GDP.

• Nominal GDP is the sum value of all produced goods and services at current prices. This is the GDP
that is explained in the sections above. Nominal GDP is more useful than real GDP when comparing
sheer output, rather than the value of output, over time.

• Real GDP is the sum value of all produced goods and services at constant prices. The prices used in
the computation of real GDP are gleaned from a specified base year. By keeping the prices constant in
the computation of real GDP, it is possible to compare the economic growth from one year to the next
in terms of production of goods and services rather than the market value of these goods and services.

• In this way, real GDP frees year-to-year comparisons of output from the effects of changes in the price
level.
 GDP DEFLATOR

The Gross Domestic Product (GDP) deflator is a measure of general price inflation. It
is calculated by dividing nominal GDP by real GDP and then multiplying by 100.
Nominal GDP is the market value of goods and services produced in an economy,
unadjusted for inflation (It is the GDP measured at current prices). Real GDP is
nominal GDP, adjusted for inflation to reflect changes in real output (It is the GDP
measured at constant prices).
GDP Deflator = Nominal GDP x 100
Real GDP
 GROSS NATIONAL PRODUCT (GNP)

GNP is the aggregate final output of citizen and businesses of an economy in a year.
The difference between GDP and GNP arises because of the fact that a part of any country’s
total output is produced by factors which are actually owned by other nation(s). Thus, Net
Factor Income from Abroad (NFIA) is the difference between income received from abroad for
rendering factor services and income paid towards services rendered by foreign nationals in
the domestic territory of a country.

GNP is defined as the sum of Gross Domestic Product and Net Factor Income from Abroad.
GNP = GDP + NFIA
Thus GNP of India would count goods and services produced by all Indians, regardless of
where they work.

NOTE: GNP will be less than GDP when a country makes more payment than it receive from
abroad.
 NET DOMESTIC PRODUCT AND NET NATIONAL PRODUCT

While calculating GDP and GNP we ignore depreciation of assets or capital

consumption; else they would not reveal complete flow of goods and services
through various sectors. But in reality the process of production uses up a
certain amount of fixed capital by way of wear and tear by a process termed as
depreciation, or capital consumption allowance.
In order to arrive at NDP and NNP, we deduct depreciation from GDP and GNP.
The word “net” refers to the exclusion of that part of total output which
represents depreciation, wear and tear and replacements during the year of
accounting.

Hence, NDP = GDP – Depreciation

And NNP = GDP – Depreciation + NFIA
Or NNP = GNP – Depreciation
 CONCEPT OF-
PI, PDI AND PER CAPITA
INCOME
 PERSONAL INCOME

Personal income is the total income received by the individuals of a country

from all sources before direct taxes in one year.

Personal income can include not only wages, but also a number of additional
incomes (for example, dividends on securities, transfers, pensions, social
benefits, rent, and so on).

Personal income is calculated before deducting personal taxes charged to the

subject.

Personal income is an indicator that shows the real well-being of people and
their ability to pay (before taxes)
 PERSONAL DISPOSABLE INCOME

Personal Disposable Income is the income which can be spent on

consumption by individuals and families.

Personal disposable Income = Personal Income – Personal Taxes

A worker’s disposable personal income (DPI) is how much money they have to
spend after subtracting taxes, including income tax, Social Security tax,
and Medicare tax. Individuals can either spend or save disposable personal
income.
 PER CAPITA INCOME

The average income of the people of a country in a particular year is called per
capita income.
Per capita income is income per head of a country for a year.

National Income
Per capita Income = ---------------------------
Total Population
 MEASUREMENT OF NATIONAL INCOME

1. GNP is the sum of value added of all firms in same period that is the total value of final
goods and services produced. GNP is a monetary measure because there is no other way
of adding up different sorts of goods and services produced except with their money
value.

2. GNI values national output as a sum of total payments made to the factors of production
for their services in production or alternatively, the earnings received by various factors.

3. GNE values national output by taking the value of expenditure on goods and services
produced (that is, aggregate expenditure on consumption and investment).

The terms “Gross National Product, Gross National Income and Gross National Expenditure”
may be used synonymously. In principle, these three variants will always be equal, that is GNP=
GNI = GNE. However, in practice, for some statistical data problem, this may not happen, and
statistical discrepancy may arise.
 NATIONAL INCOME
CALCULATION – PRODUCT
METHOD
 PRODUCT METHOD

As per the product method of estimating national income, also called

national income by Industry of Origin.

The product method adds up the market value of all final goods and services
produced in the country by all firms across all industries.
 Steps to calculate National Income by Product Method

This method involves the following steps:

1. The economy is divided on basis of industries, such as agriculture, fishing, mining,
large scale manufacturing, small scale manufacturing, electricity, gas, etc.
2. The physical units of output are then interpreted in money terms, i.e., by taking
market price of all the products
3. The total values thus obtained are then added up.
4. The indirect taxes are subtracted and the subsidies are added. This gives the GDP
or GNP, as the case may be, depending upon what data are being used.
5. The net value is calculated by subtracting depreciation from the total value thus
obtained, in order to arrive at NNP.

A word of caution to be repeated here is that goods produced in a particular year and
only in their final form are to be considered.
Calculation of NNP at FC
Product Method

Gross value added in the primary sector at

Market Price
+
Gross value added in the Secondary Sector at
Market Price
+
Gross Value Added in the Tertiary Sector at
Market Price

GDP at Market Price – Depreciation

NDP at Market Price - NIT

NDP at Factor cost + NFIA

NNP at Factor cost

 LIMITATIONS OF PRODUCT METHOD

• Problem of double counting

• Not applicable to tertiary sector
• Exclusion of Non Marketed products
 Types of Product Methods

National income by Product Method can be calculated in two ways:

• Final Product Method

• Value Added Method

 EXAMPLE

If a manufacturer sells a mobile phone to a retailer for Rs. 3000 and the retailer
sell it to the consumer at Rs. 5000, how much has the mobile contributed to
GDP? Is it Rs. 8000? No. if we do that, it would be double counting. Instead we
would either count the final value (Rs. 5000) or the value added at each stage
(Rs.3000 by the manufacturer and Rs.2000 by the retailer). The sum of all such
values added by all industries in the economy is known as Gross Value Added
(GVA) at basic prices.
 NATIONAL INCOME
CALCULATION – INCOME
METHOD
 INCOME METHOD

According to the Income method, it is the net income received by all citizen of
the country in a particular year that is added up, i.e., total rents, net wages, net
interest and net profits. However, income received in the form of transfer
payment is not included.

This is the GDP at factor; now we add the money sent by the citizens of the
nation from abroad and deduct the payments made to foreign nationals
(individuals and firms) we get Gross National Income (GNI)
 Income method involves the following steps:

1. The economy is divided on the basis of income groups, such

as wages/salary earners, rent earners, profit earners, and so
on.
2. Income of each of these groups is calculated.
3. Income of all the earners is added, including income from
abroad and undistributed profits.
From (3), income earned by foreigners and transfer payment
made in the year are subtracted. In other words,

GNP at factor cost = Rent + Interest + Profits + other Income +

(Income from Abroad – Payments made to foreigners) – Transfer
Payments.
Calculation of NNP at FC
Income Method

COE (Compensation of Employees)

+
OS (Operating surplus)
+
MI (Mixed Income)

Net Domestic Income

Net Factor Income from Abroad

National Income (NNP at Factor Cost)

 Limitations of Income Method

• Exclusion of Non Monetary Income

• Exclusion of Non Marketed Services
Calculation of National
Income – Expenditure
Method
 Expenditure Method

We have seen that whatever is earned is spent either on consumption or on

investment. Therefore, it is possible to calculate national income by
expenditure method.

According to the expenditure method, the total expenditure incurred by the

society in a particular year is added together to get the year’s national income;
such expenditure includes personal consumption expenditure, net domestic
investment, government expenditure on goods and services, and net foreign
investment.
 Steps of calculating National Income by Expenditure Method

This concept rests on the assumption that national income equals national
expenditure.

• Consumption expenditure
• Investment Expenditure
• Government Expenditure
• Net Exports
 Precautions Regarding Expenditure Method

• Only final expenditure

• Expenditure on second-hand goods
• Expenditure on share and bonds
• Expenditure on transfer payment by the government
 Expenditure Method

Private Final Consumption Expenditure

+
Government Final Consumption Expenditure
+
Gross Domestic Fixed Capital Formation
+
Change in Stock or Inventory Investment
+
Net Exports (Export – Import)

GDP at Market Price – Depreciation

NDP at Market Price - NIT

NDP at Factor cost + NFIA

NNP at Factor cost

NATIONAL INCOME –
DIFFICULTIES AND
LIMITATION
 Difficulties in the measurement of National Income

• Non Monetized Transactions

• Unorganized Sector
• Multiple Source of Earning
• Categorization of Final Goods and Services
• Inadequate Data
 Limitations in the measurement of National Income

The three main limitations to national income accounting are:

Errors in Measurement: Black Market and underground activities are not included when calculating GDP. This is
because there is no way to accurately measure black market activity. In the United States, this is a relatively small
percentage of the total GDP; however, in many other less developed countries, it can go as high as 70% of the
country's total GDP. Another big measurement error is inflation. It is adjusted according to base prices and
various other things and the range of possible inflation can be as much as 1% to 15% in some places.
Subcategories that are Misrepresented: The various interpretations of what should be included in consumption
or government spending plays a big part in the overall determination of GDP. Decisions are made about what is to
be included where, but minor discrepancies will always arise.
Welfare is NOT Measured: GDP only measures the market activity and does not take welfare into account. The
economic activity of a country could rise, while welfare could possibly have fallen. Different situations may occur
that have a negative impact on the people which cause them to increase spending, therefore increasing the GDP.
Money And its
Functions
 Money

Money is an economic unit that functions as a generally recognized medium

of exchange for transactional purposes in an economy.

Professor Coulborn defines money as “the means of valuation and of

payment; as both the unit of account and the generally acceptable medium

of exchange.”

By money Friedman means “literally the number of dollars people are

carrying around in their pockets, the number of dollars they have to their

credit at banks in the form of demand deposits and commercial bank time

deposits”. Thus he defines money as “the sum of currency plus all adjusted

deposits in commercial banks”.

 Functions of Money

1. Money as the Medium of Exchange:

Money came into use to remove the inconveniences of barter as money has separated the
act of purchase from sale. Medium of exchange is the basic or primary function of money.
People exchange goods and services through the medium of money. Money acts as a
medium of exchange or as a medium of payments. Money by itself has no utility (except
perhaps to the miser). It is only an intermediary.
2. Money as a Unit of Account or Measure of Value:
Money serves as a unit of account or a measure of value. Money is the measuring rod, i.e., it
is the units in terms of which the values of other goods and services are measured in money
terms and expressed accordingly Different goods produced in the country are measured in
different units like cloth m metres, milk in litres and sugar in kilograms.
Without a common unit, exchange of goods becomes very difficult Values of all goods and
services can be expressed easily in a single unit called money
 Functions of Money

3. Money as the Standard of Deferred Payments:

Deferred payments are payments which are made some time in the future. Debts are usually
expressed in terms of the money of account. Loans are taken and repaid in terms of money.
The use of money as the standard of deterred or delayed payments immensely simplifies
borrowing and lending operations because money generally maintains a constant value
through time.

4. Money as a Store of Value:

Wealth can be stored in terms of money for future. It serves as a store value of goods in
liquid form. By spending it, we can get any commodity in future. Keynes places great
emphasis on this function of money. Holding money is equivalent to keeping a reserve of
liquid assets because it can be easily converted into other things.
 Motives for holding Money

• Transaction Motive

• Precautionary Motive

• Speculative Motive
Money Supply
 Money Supply

• The money supply is the total stock of money that is in circulation in an economy on any

specific day.

• This includes all the notes, coins and demand deposits held by the public on such a day.

Such as money demand, money supply is also a stock variable

• Now there are essentially three main sources of money supply in our economy. They are

the produces of the money and are responsible for its distribution in the economy. These are

 The government who produces all the coins and the one rupee notes

 The Reserve Bank of India (RBI) which issues all the paper currency

 And commercial banks as they create the credit as per the demand deposits
 Measures of Money Supply in India

There are four alternative measures of money supply labelled as M1, M2, M3 and M4.

M1 (Narrow Money)

M1 includes all the currency notes being held by the public on any given day. It also includes

all the demand deposits with all the banks in the country, both savings as well as current

account deposits. It also includes all the other deposits of the banks kept with the RBI. So M1

= CC + DD + Other Deposits

M2

M2, also narrow money, includes all the inclusions of M1 and additionally also includes the

saving deposits of the post office banks. So M2 = M1 + Savings Deposits of Post Office

Savings
 Measures of Money Supply in India

M3 (Broad Money)

M3 consists of all currency notes held by the public, all demand deposits with the bank,

deposits of all the banks with the RBI and the net Time Deposits of all the banks in the

country. So M3 = M1 + time deposits of banks.

M4

M4 is the widest measure of money supply that the RBI uses. It includes all the aspects of

M3 and also includes the savings of the post office banks of the country. It is the least liquid

measure of all of them. M4 = M3 + Post office savings

 Quantity Theory of Money: Fisher Version
• This theory was proposed by Irving Fisher.

• According to quantity Theory, any given percentage increase (or decrease) in the quantity of money will lead to the
same percentage decrease (or increase) in the general price level.

• In other words, if the quantity of money is doubled, the price level will also double and the value of money will be
one half. On the other hand, if the quantity of money is reduced by one half, the price level will also be reduced by
one half and the value of money will be twice.

• Initially the theory considered:

MV=PT

P= MV/T

Where: P= General price level

M= Supply of Money
V= Velocity with which Money circulates
T= Transaction volume of Goods and services.
 Quantity Theory of Money: Fisher Version
•Irving Fisher further extended the equation of exchange so as to include demand (bank)
deposits (M’) and their velocity, (V’) in the total supply of money.

Thus, the equation of exchange becomes:

 Quantity Theory of Money: Assumptions

 P is passive factor in the equation of exchange which is affected by the other factors.
 The proportion of M’ to M remains constant.
 V and V’ are assumed to be constant and are independent of changes in M and M’.
 T also remains constant and is independent of other factors such as M, M, V and V.
 It is assumed that the demand for money is proportional to the value of transactions.
 The supply of money is assumed as an exogenously determined constant.
 The theory is applicable in the long run.
 It is based on the assumption of the existence of full employment in the economy.
 Quantity Theory of Money: Income Version
• Due to the dissatisfaction with the transactions approach , a modified income version of the theory was put
forward, where quantity was put forward in terms of real income.

• Income version can be expressed as:

MV= Py
Where: M = Total quantity of money in circulation
V= Income velocity of money
P= average level of price of only the final goods and services.
y= real income

• Assuming that V is constant and y is determined by forces of real sector, the theory arrives at a conclusion that
autonomous changes in the supply of money, M lead to equi proportionate changes in the price level P.
 Criticism of Fisher Version

1) Interdependence of variables:

(i) M Influences V – As money supply increases, the prices will increase. Fearing further rise in price in
future, people increase their purchases of goods and services. Thus, velocity of money (V) increases
with the increase in the money supply (M).
(ii) M Influences V’ – When money supply (M) increases, the velocity of credit money (V’) also
increases. As prices increase because of an increase in money supply, the use of credit money also
increases. This increases the velocity of credit money (V’).
(iii) P Influences T – Fisher assumes price level (P) as a passive factor having no effect on trade (T). But,
in reality, rising prices increase profits and thus promote business and trade
 Criticism of Fisher Version

iv) P Influences M – According to the quantity theory of money, changes in money supply (M) is the
cause and changes in the price level (P) is the effect. But, critics maintain that a change in the price
level occurs independently and this later on influences money supply.
T Influences V – If there is an increase in the volume of trade (T), it will definitely increase the velocity
of money (V).
2. Unrealistic Assumption of Long Period
3. Unrealistic Assumption of full Employment
4. The quantity theory assumes that the values of V, V’, M’ and T remain constant. But, in reality, these
variables do not remain constant.
5. Simple Truism
 Demand of Money

Money is demanded not for its own sake (i.e., for hoarding it), but for transaction purposes. The demand for money
is equal to the total market value of all goods and services transacted. It is obtained by multiplying total amount of
things (T) by average price level (P).

Note: Fisher’s equation of exchange represents equality between the supply of money or the total value of
money expenditures in all transactions and the demand for money or the total value of all items transacted

Supply of money = Demand for Money

Or
Total value of money expenditures in all transactions = Total value of all items transacted
MV = PT
or
P = MV/T
 Demand of Money

• The equation of exchange is an identity equation, i.e., MV is identically equal to PT (or MV = PT).

• It means that in the ex-post or factual sense, the equation must always be true.

• The equation states the fact that the actual total value of all money expenditures (MV) always

equals the actual total value of all items sold (PT).

• What is spent for purchases (MV) and what is received for sale (PT) are always equal; what

someone spends must be received by someone. In this sense, the equation of exchange is not a

theory but rather a truism.

 Quantity Theory of Money: Cambridge Version

• This Version of quantity theory of money was developed by group of Cambridge economists like Pigou, Marshall,
Robertson and Keynes in the early 1900s.
• According to Cambridge economists, people wish to hold cash to finance transactions and for security against
unforeseen needs. They also suggested that an individual’s demand for cash or money balance is proportional to his
income i.e larger the income, greater will be demand for money.
• Demand Function for money is:
Md= KY
Where Md= the amount of money demanded
K= a constant
Y= national income in money terms
 Quantity Theory of Money: Cambridge Version

• Now,

K= Md/Y
This, K gives the proportional of money income which public likes to hold as money.
We have,
y=Y/P
Where, y= the real national income
P= general price level
Combining the above equations we get,
Md= Kpy
 Quantity Theory of Money: Cambridge Version

• The equilibrium condition for the money market is:

Md=Ms
Thus,
Ms= Kpy
Hence,
Ms1/K=MsV=Py
The above equation looks very similar to the Fisher’s equation, except for V, which represents income velocity
instead of transaction velocity.
Credit Creation by Commercial Banks
 Credit Creation
• Credit basically means getting the purchasing power now and promising to pay at some time in future.
• A bank keeps a certain part of its deposits as a minimum reserve to meet the demands of its depositors and lends out the
remaining to earn income. Every bank loan creates an equivalent deposit in the bank. Therefore, credit creation means
expansion of bank deposits.

Basic Concepts of Credit Creation

 Bank as a Business Institution which tries to maximize profits through loans and advances from deposits.
 Bank Deposits: They are of two types:
(a) Primary deposits: A bank accepts cash from customer and open a deposit in his name.. This does not mean credit
creation.
(b) Secondary or Derivative Deposits: A bank grants loans and advances and instead of giving cash to the borrower, opens
a deposit account in his name. This is secondary or derivative deposit and creation of derivative deposit means credit
creation.
(c) Cash reserve ratio (CRR): Percentage of total deposits which the banks must hold in cash reserves for meeting the
depositor's demand for cash.
 Credit Creation by a Single Bank

In a single bank system, one bank operates all the cash deposits and claques. The process of creating credit is
explained with the hypothetical example below:
 Credit Creation by a Single Bank

Let’s assume that the bank requires to maintain a CRR of 20 percent.

•If a person (person A) deposits 1,000 rupees with the bank, then the bank keeps only 200 rupees in the
cash reserve and lends the remaining 800 to another person (person B). They open a credit account in
the borrower’s name for the same.
•Similarly, the bank keeps 20 percent of Rs. 800 (i.e. Rs. 160) and advances the remaining Rs. 640 to
person C.
•Further, the bank keeps 20 percent of Rs. 640 (i.e. Rs. 128) and advances the remaining Rs. 512 to
person D.
This process continues until the initial primary deposit of Rs. 1,000 and the initial additional reserves of
Rs. 800 lead to additional or derivative deposits of Rs. 4,000 (800+640+512+….).
Adding the initial deposits, we get total deposits of Rs. 5,000. In this case, the credit multiplier is 5
(reciprocal of the CRR) and the credit creation is five times the initial excess reserves of Rs. 800 .
 Credit Creation by Multiple Bank System
The banking system has many banks in it and it cannot grant loans in excess of the cash it creates. When a bank creates
a derivative deposit, it loses cash to other banks. The loss of deposit of one bank is the gain of deposit for some other
bank. This transfer of cash within the banking system creates primary deposits and increases the possibility for further
creation of derivative deposits. Here is an illustration to explain this process better:
 Deposit Multiplier

This is the amount of money all banks must keep on hand in their reserves. It allows them to function
on a day-to-day basis, cutting the risk of depleting their supplies to satisfy withdrawal requests from
their customers.
The deposit multiplier is the inverse of the required reserves. So if the required reserve ratio is 20%, the
deposit multiplier ratio is 80%. It is the ratio of the amount of a bank's checkable deposits—demand
accounts against which checks, drafts, or other financial instruments can be negotiated—to its reserve
amount.
A bank's deposit multiplier can be calculated using the following formula:

Deposit Multiplier= 1/ Reserve Ratio

 Tools of Monetary Policy

The Reserve Bank of India employs various instruments of monetary policy in India to achieve the objectives of price
stability and higher economic growth. Some of the important instrument or tools of monetary policy in India are:

 Open Market Operations (OMO): It is the process of buying and selling of government securities, bond or Treasury

Bills (T-Bills) to regulate the money supply in economy.

 Cash Reserve Ratio (CRR): It refers to the cash which banks have to maintain with the Reserve Bank of India as

percentage of Net Demand and Time Liabilities (NDTL). An increase in CRR makes it mandatory for banks to hold large

portion of their deposits with the RBI.

 Statutory Liquidity Ratio (SLR): Apart from CRR, the banks in India are required to maintain liquid assets in the

form of gold, cash and approved securities. The increase/decrease in SLR affects the availability of money for credit

with banks.
 Tools of Monetary Policy

 Liquidity Adjustment Facility (LAF): Under Liquidity Adjustment Facility (LAF) the banks purchase money from RBI on

repurchase agreements.
• Repo Rate: It is the interest rate at which the Reserve Bank provides overnight liquidity to banks against the collateral
of government and other approved securities under the liquidity adjustment facility (LAF)
• Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on an overnight basis, from
banks against the collateral of eligible government securities under the LAF
 Selective Credit Control: Under this method, the central influence the credit growth in country through following
techniques:
• Specifying the margin requirements and differential rate of interests
• Regulating the credit for consumer durables
 Moral Suasion: The central persuades the commercial banks to regulate the credit growth through oral and verbal
communication.
Inflation
Inflation
 Inflation

 Inflation may be defined as ‘a sustained upward trend in the general

level of prices’ and not the price of only one or two goods.

 G. Ackley defined inflation as ‘a persistent and appreciable rise in the

general level or average of prices’

 In a broad sense , inflation is that state in which the prices of goods and

services rise on the one hand and value of the money falls on the other.

All the above definitions are showing that inflation is a continuous

process and they also show that inflation is a condition in which prices

rise and money value decreases. Due to inflation , the real value of money

decreases , i.e., the purchasing power decreases

 Causes of Inflation

1) Increase in Money Supply

2) Increase in disposable income

3) Increase in aggregate spending.

4) Increase in population of the country

 Effects of Inflation

• Investment
• Interest rates
• Exchange rates
• Unemployment
• Stocks
• Decrease in the purchasing power
• Change the allocation of income
 Causes of Inflation

1) Increase in Money Supply

2) Increase in disposable income

3) Increase in aggregate spending.

4) Increase in population of the country

 Types of Inflation

1. On the Basis of Causes:

• This type of inflation is caused by the printing of currency notes.
2. Credit inflation:
• Being profit-making institutions, commercial banks sanction more loans and
advances to the public than what the economy needs. Such credit
expansion leads to a rise in price level.
3. Deficit-induced inflation:
• The budget of the government reflects a deficit when expenditure exceeds
revenue. To meet this gap, the government may ask the central bank to
 Types of Inflation
4. Demand-pull inflation:
• An increase in aggregate demand over the available output leads to a rise in the price level. Such
inflation is called demand-pull in­flation (henceforth DPI).
• If the supply of money in an economy ex­ceeds the available goods and services, DPI appears.
5. Suppressed Inflation: This is a state when inflationary conditions exist, but the government makes
such policies which temporarily keep prices under check and as soon as these checks are removed,
inflation bursts out. It is a short run measure.
6. Disinflation: It is a process of keeping a check on price rise by deliberate attempts. It is a well planned
process to bring down prices moderately from a very high level.
 Types of inflation
7. Cost Push Inflation:
• Cost-push inflation occurs when we experience rising prices due to higher costs of
production and higher costs of raw materials.
• It is determined by supply-side factors, such as higher wages and higher oil prices.
• Cost-push inflation is different to demand-pull inflation which occurs when aggregate
demand grows faster than aggregate supply.
• It can lead to lower economic growth and often causes a fall in living standards,
though it often proves to be temporary.
 Types of Inflation

8. Creeping Inflation:

• Creeping or mild inflation is when prices rise 3% a year or less.

• This kind of mild inflation makes consumers expect that prices will keep

going up. That boosts demand.

• Consumers buy now to beat higher future prices.

 Types of Inflation
9. Walking Inflation:
• This strong, or destructive, inflation is between 3-10% a year.
• It is harmful to the economy because it heats-up economic growth too fast.
• People start to buy more than they need to avoid tomorrow's much higher prices.
• This increased buying drives demand even further so that suppliers can't keep up.
• As a result, common goods and services are priced out of the reach of most people.
 Types of Inflation
10. Galloping Inflation:
• When inflation rises to 10% or more, it wreaks absolute havoc on the economy.
• Money loses value so fast that business and employee income can't keep up
with costs and prices.
• Foreign investors avoid the country, depriving it of needed capital.
• The economy becomes unstable, and government leaders lose credibility.
• Galloping inflation must be prevented at all costs.
 Types of Inflation

11. Hyperinflation:
• Hyperinflation is when prices skyrocket more than 50% a month. It is very
rare.
• In fact, most examples of hyperinflation occur when governments print
money to pay for wars.
• Examples of hyperinflation include Germany in the 1920s, Zimbabwe in
the 2000s, and Venezuela in the 2010s.
 Types of Inflation
12. Stagflation:
• Stagflation is a combination of stagnant economic growth, high unemployment,
and high inflation.1
• It's an unnatural situation because inflation is not supposed to occur in a weak economy.
• In a normal market economy, slow growth prevents inflation.
• As a result, consumer demand drops enough to keep prices from rising.
• Stagflation can only occur if government policies disrupt normal market functioning.
• Stagflation occurs when the government or central banks expand the
money supply at the same time they constrain supply.
• The most common culprit is when the government prints currency.

• It can also occur when a central bank's monetary policies create credit.

• Both increase the money supply and create inflation.

 Implications of Inflation

 Un employment

 Decreasing the purchasing power

 Decrease in stock.

 Exports decline.

 Breakdown of monetary system.

Investment fall.
 Control of Inflation

 Monetary Measures: Under monetary measures, the central bank of the

country uses various methods of credit control to keep a check on inflation.

Some of the important measures adopted by central bank includes:

• Increasing discount rate

• Higher Reserve ratio

• Open market operations

• Selective credit control.

 Control of Inflation

 Fiscal Measures: Under these measures, the government may reduce public

expenditure or increase public revenue to keep a check on inflation.

• Reducing Public expenditure

• Increasing Public revenue.

Unemployment
and Philips
Curve
 Unemployment

The state of being without any work yet looking for work is called unemployment. Economists

distinguish between various overlapping types of and theories of unemployment, including

cyclical or Keynesian unemployment, frictional unemployment, structural unemployment and

classical unemployment.
 Philips Curve
 In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and
the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the
rate of inflation. While it has been observed that there is a stable short run tradeoff between unemployment
and inflation, this has not been observed in the long run.
 In the paper Phillips describes how he observed an inverse relationship between money wage changes and
unemployment in the British economy over the period examined.
 A. W. H. Phillips’s study of wage inflation and unemployment in the United Kingdom from 1861 to 1957 is a
milestone in the development of macroeconomics. Phillips found a consistent inverse relationship: when
unemployment was high, wages increased slowly; when unemployment was low, wages rose rapidly.
 Phillips had mainly noted the relationship between the rate of change of money changes and the level of
unemployment in an economy . It was later that other economists modified the curve and replaced the other
variable with inflation.
Philips Curve
 Adaptive Expectations

 This was proposed by Milton Friedman

 According to Friedman, people form their expectations on the basis of previous period of

inflation and change or adapt their expectations on the basis of previous period rate of inflation

and change or adapt their expectations only when the actual inflation turns out to be different

from their expected rate.

 The government can easily surprise workers through unexpected monetary policy changes. As

agents are trapped by the money illusion, they are unable to correctly perceive price and wage

dynamics, so, for Friedman unemployment can always be reduced through monetary expansion.
 Rational Expectations

 Rational expectations is an economic theory that states that individuals make decisions based

on the best available information in the market and learn from past trends. Rational expectations

suggest that people will be wrong sometimes, but that, on average, they will be correct.
POLICY INEFFECTIVENESS DEBATE
 Introduction

• This Policy Ineffectiveness proposition was developed by Thomas Sargent

and Neil Wallace.
• According to which the government could not successfully intervene in the
economy if attempting to manipulate output. If the government employed
monetary expansion in order to increase output, agents would foresee the
effects, and wages and price expectations would be revised upwards
accordingly. Real wages remains constant and therefore so does output, no
money illusion occurs. Only stochastic (random) shocks to the economy
can cause deviations in the employment from its natural level.
 Active Policy
• The government use different tools to steer the economy.
Recall that monetary policy, the toolbox of RBI, includes
performing open market operations, and changing both the
reserve requirement and the federal funds interest rate.
• Recall also that fiscal policy, the toolbox of the government,
includes changing both taxes and government spending.
• All of these tools can be controlled actively. That is, if the RBI
or the government decide to use expansionary policy, they
can simply select a tool from the policy toolbox and use it.
• In this way, active policy is defined as actions by the RBI or by the
government that are done in response to economic conditions.

• That is, the RBI or the government choose to respond to something in

the economy by undertaking a specific policy.

• This is also called discretionary policy.

 Advantages of Active Policy

• Active policy allows policymakers to respond to shifts in a complex economy

and steer the economy in the optimal direction.
• For instance, an excellent policymaker may be able to keep the economy
growing steadily without inflation if he/she is given complete control of
macroeconomic policy.

• Similarly, active policy, at least in theory, gives control to those individuals

who are considered optimally capable to deal with the fluctuations in the

economy.
• That is, active policy allows the sharpest policymakers of the time to

control the economy.

• Finally, the ability to create different expectations between the

policymakers and the public can be an advantageous policy tool.

 Difficulties of Active policy
• It relies on the actions and experiences of the policymakers in the RBI and in the
government.
• The weaknesses or prejudices of these policymakers can be translated into official
economic policy.
• With active policy, policymakers can say one thing and do another. There may be
benefits to making the public believe that something different is occurring in the
economy rather than what actually is occurring.
• Thus, it is reasonable to claim that active policy leaves monetary policy and fiscal
policy open to not only accidental human error but also to malicious and self-serving
acts.
 Passive Policy
• In contrast to active (or discretionary) policy is passive policy
(or policy by rule). Under this system, macroeconomic policy
is conducted according to a preset series of rules.
• These rules take into account many macroeconomic
variables and dictate the best course of action given these
conditions.
• For instance, a passive policy may follow the rule that in
order to stabilize the economy the interest rate must be
dropped one point whenever the nominal GDP falls one
percent.
 Advantages of Passive Policy

• The short-term desires of policymakers out of the list of possible goals

of macroeconomic policy.
• Instead, the policymakers are simply present to carry out the
macroeconomic policy and to ensure that everything runs smoothly.
• Policy by rule uses policymakers to implement, rather than design,
macroeconomic policy.
• Similarly, another advantage of passive policy is that the policy rules
are based on optimizing the economy in the long run and are less likely
to trade short run prosperity for long run growth.
 Disadvantages of Passive policy
• Passive policy is not immune to the problems that plague active
policy, however. For instance, passive policy must be written by
policymakers at some point.
• Thus, policy rules can contain the biases of the policymakers of a
different time--biases that are perhaps quite inappropriate to
the current economic climate.
• And any outright errors in judgment or theory made by these
policymakers will be incorporated into the rules and will thus be
present as long as the rules are in effect.
 Which Policy to use?
• Whichever method of policy is desired, a major problem
exists.
• This problem is based on the fact that it takes time for
economic problems to be noticed and dealt with.
• Detection lags refer to the amount of time between the
onset of an economic problem and its detection.
• Policy lags, on the other hand, refer to the amount of time
between the enactment of macroeconomic policy and the
moment when that policy takes effect.
• The delays created by lags can have one final and very
important effect.
• If lags are so long that the economy corrects itself before
the macroeconomic policies take effect, then the policies
can actually worsen the situation.
• For instance, if the government uses fiscal policy to
stimulate the economy, but the economy begins to correct
itself before the policy takes effect, then the economy will
be over-stimulated, resulting in possible inflation
Price Indices
 Introduction
• Price indices (also referred to as price indexes) show the change in general
price level in percentage terms over time. They seek to calculate, the
changes in the price of a very large ‘shopping basket’ of the products,
bought by consumers.
• There are three major indices used in India for comprehensive assessment
of prices and production.
 Consumer Price index (CPI)
 Index of Industrial Production (IIP)

 Wholesale Price Index (WPI)

 Consumer Price Index (CPI)
• CPI is a measure of change in retail prices of goods and services consumed by defined
population group in a given area with reference to a base year. The consumer price index
number measures changes only in one of the factors- prices.
• This basket of goods and services represents the level of living or the utility derived by
the consumers at given levels of their income, prices and tastes.
• It is calculated by Central Statistics Office (CSO) < In the Ministry of Statistics and
Programme Implementation (MOSPI)
• It is brought out on monthly basis for urban, rural and all India. Presently the consumer
price indices compiled in India are CPI for Industrial workers CPI(IW), CPI for
Agricultural Labourers CPI(AL) & Rural Labourers CPI(RL) and CPI ( Urban) and
CPI(Rural).
• The index is a measure of the average price which consumers spend on a market-based
“basket” of goods and services. Inflation based upon the consumer price index (CPI) is
the main inflation indicator in most countries.
 Index of industrial Production (IIP)
• Index of Industrial Production (IIP) measures the quantum of changes in the industrial
production in an economy and captures the general level of industrial activity in the country. It is a
composite indicator expressed in terms of an index number which measures the short term changes
in the volume of production of a basket of industrial products during a given period with respect to
the base period(2004).
• It is calculated by Central Statistics Office (CSO) < In the Ministry of Statistics and Programme
Implementation (MOSPI)
• It is brought out on monthly basis with the time lag of six weeks from the reference month (on 12th
of the Month, or if 12th is a Gazetted Holiday, on the previous working day).Although IIP is just a
short term indicator. The actual results come with the Annual Survey of Industries (ASI).
• Industrial Production in the IIP comprises three distinct groups of industry, (a) Mining,
(b) Manufacturing and (c) Electricity.
• IIP covers 682 items comprising Mining (61 items), Manufacturing (620 items) & Electricity (1 item).
The weights of the three sectors are 14.16%, 75.53% and 10.32% respectively and are on the basis
of their share of GDP at factor cost during 2004-05.
 Wholesale Price Index (WPI)
• In India, the Wholesale price index (WPI) is the main measure of inflation. The WPI measures the
price of a representative basket of wholesale goods. WPI captures price movements in a most
comprehensive way. It is widely used by Governments, banks, industry and business circles.
• It is calculated by – Office of the Economic Adviser <In DIPP (Department of Industrial Policy and
Promotion) < In Ministry of Commerce & Industry.
• It is released on three duration basis. A) Weekly: on Every Thursday for Primary Articles and Fuel
Group. B) Monthly : On 14th of Every month for all commodities. C) Final:Final list is released every
two months (~EIGHT weeks). When they get authentic price data for all commodities.
• Wholesale price index is divided into three groups: Primary Articles (20.1 percent of total
weight), Fuel and Power (14.9 percent) and Manufactured Products (65 percent).
• The current WPI has a basket of 676 items.
• The Wholesale Price Index focuses on the price of goods traded between corporations, rather than
goods bought by consumers, which is measured by the Consumer Price Index. The purpose of the
WPI is to monitor price movements that reflect supply and demand in industry, manufacturing and
construction. This helps in analyzing both macroeconomic and microeconomic conditions of an
economy.