Introduction to Macroeconomics

INTRODUCTION AND OVERVIEW

(SLIDES 1-7)

THE CIRCULAR FLOW OF INCOME, EXPENDITURE AND OUTPUT (SLIDES 8-27) INTRODUCTION AND OVERVIEW DEFINITIONS MACROECONOMICS: THE STUDY OF THE AGGREGATE (TOTAL) BEHAVIOUR OF THE WHOLE ECONOMY.
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Macroeconomics
MICROECONOMICS: WE COVERED LAST TERM THAT IT IS THE STUDY OF THE ECONOMIC BEHAVIOUR OF INDIVIDUAL AGENTS, INTERACTING IN MARKETS. MACROECONOMIC AGGREGATES GDP: MONEY VALUE OF ALL FINAL GOODS AND SERVICES PRODUCED WITHIN A COUNTRY IN A GIVEN YEAR; OUTPUT. UNEMPLOYMENT RATE: % OF PEOPLE IN THE LABOUR FORCE NOT WORKING BUT SEARCHING FOR WORK. INFLATION RATE: % RISE IN THE AVERAGE PRICE OF ALL GOODS AND SERVICES. SAVING AND INVESTMENT RATES: WHAT IS 2 THE MEANING AND IMPLICATIONS

Nominal Vs. Real

NOMINAL: AT CURRENT PRICES (NOT ADJUSTED FOR INFLATION) REAL: AT CONSTANT PRICES (ADJUSTED FOR INFLATION) REAL GDP = REAL OUTPUT AN INCREASE IN REAL GDP MEANS "A BIGGER ECONOMY"; AN INCREASE IN REAL GDP PER CAPITA (PER PERSON) MEANS "A RICHER ECONOMY". BUSINESS CYCLE: PERIODS OF GROWTH OF REAL OUTPUT ALTERNATE WITH PERIODS OF FALLING OUTPUT (RECESSIONS/ BOOMS, MAY OR MAY NOT BE WITH DEFINITE PERIODICITY )

Balance of Payments
BALANCE OF (INTERNATIONAL) PAYMENTS: MONEY VALUE OF INDIAN GOODS, SERVICES AND ASSETS PURCHASED BY THE REST OF THE WORLD... MINUS THE MONEY VALUE OF FOREIGN GOODS, SERVICES AND ASSETS PURCHASED BY THE INDIANS. EXCHANGE RATE: INDIAN RUPEE PRICE OF A UNIT OF FOREIGN CURRENCY. OVERVIEW OF THE COURSE 1. EXPLAIN THE TIME-SERIES BEHAVIOUR OF THE MACROECONOMIC AGGREGATES: OUTPUT,INFLATION,UNEMPLOYMENT, EXCHANGE RATE, BOPs
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Overview
UNDERSTAND THE ROLE AND EFFECT OF POLICY: I. FISCAL POLICY: USE OF GOVERNMENT SPENDING AND TAXATION CHANGES TO AFFECT THE AGGREGATE ECONOMY. I.E., THE EFFECT OF BUDGET (DEFICIT) CHANGES ON THE ECONOMY AND, THE EFFECTS OF THE ECONOMY ON THE DEFICIT! ESPECIALLY: WHAT IS A BUDGET DEFICIT? WHAT IS THE NATIONAL DEBT? WHEN ARE THESE A 5 PROBLEM?

 II. MONETARY POLICY: USE OF CHANGES IN THE MONEY STOCK OR THE INTEREST RATE TO AFFECT THE AGGREGATE ECONOMY. MONEY VERSUS INCOME. RESERVE BANK OF INDIA AND ITS ROLE IN DETERMINING THE MONEY STOCK. GOALS OF THE RBI: FULL EMPLOYMENT? PRICE STABILITY? WHAT IS THE BEST RATE OF INLATION? WHAT IS THE "NON-ACCELERATING INFLATION RATE OF UNEMPLOYMENT? 9%? (WHETHER INDEPENDENT/ IMPOSED OBJECTIVES WILL BE DISCUSSED UNDER MONETARY POLICY IN INDIA) III. PHYSICAL CONTOLS: CONTROLS LIKE INVESTMENTS, PRODUCTION/ DISTRIBUTION, 6

POLICY

POLICY DILEMMAS
WHAT ARE THE COSTS AND BENEFITS OF REDUCING THE RATE OF INFLATION (TO ZERO)? FUNDAMENTAL ISSUES: IS THE PRIVATE ECONOMY STABLE? CAN THE FISCAL OR MONETARY AUTHORITIES AFFECT THE MACROECONOMY? SHOULD THE FISCAL OR MONETARY AUTHORITIES TRY TO AFFECT THE MACROECONOMY?

THE CIRCULAR FLOW

THE CIRCULAR FLOW OF INCOME, EXPENDITURE AND OUTPUT A SIMPLE ECONOMY: NO SAVINGS OR INVESTMENT (NO FINANCIAL SECTOR) NO TAXES OR TRANSFERS (NO GOVERNMENT SECTOR) NO IMPORTS OR EXPORTS (NO FOREIGN TRADE) ONLY HOUSEHOLDS (HHs) AND BUSINESS FIRMS HOUSEHOLDS OWN ALL THE FACTORS 8 (LABOUR, CAPITAL NATURAL RESOURCES) AND

SIMPLE ECONOMY
FIRMS EMPLOY ALL THE FACTORS AND PRODUCE ALL THE GOODS AND SERVICES (OUTPUT) THE FLOW OF OUTPUT FROM FIRMS TO HHs IS MATCHED BY THE FLOW OF EXPENDITURES FROM HHs TO FIRMS. ALL EXPENDITURE = VALUE OF ALL OUTPUT THE FLOW OF FACTOR SERVICES FROM HHs TO FIRMS IS MATCHED BY THE FLOW OF FACTOR PAYMENTS (INCOME) FROM FIRMS TO HHs. ALL INCOME = ALL EXPENDITURE
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The interdependence of Goods and Factor Markets

FIRMS (suppliers of goods and services, demanders of factor services) HOUSEHOLDS (demanders of goods and services, suppliers of factor services)

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FLOWS VS STOCKS
A FLOW OCCURS CONTINUOUSLY THROUGH TIME, MEASURED IN UNITS PER TIME PERIOD. A STOCK IS AN ACCUMULATED QUANTITY, EXISTING AT A MOMENT IN TIME, MEASURED IN SIMPLE UNITS. E.G.: QUANTITY OF WATER IN A LAKE TODAY? A STOCK. QUANTITY OF WATER PASSING THROUGH A RIVER'S MOUTH PER SECOND? A FLOW. INCOME PER YEAR? A FLOW MONEY IN YOUR WALLET AND BANK ACCOUNT AS ON JAN 01, 2012?A STOCK
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RELATIONSHIPS
NEW CAPITAL GOODS PRODUCED THIS YEAR? A FLOW CAPITAL STOCK ON DEC. 31, 2011? IN OUR SIMPLE ECONOMY, ALL INCOME (Y) IS CONSUMED (C) (SPENT ON CONSUMPTION GOODS AND SERVICES) Y=C AGGREGATE EXPENDITURE (AE) = C AND THE VALUE OF ALL OUTPUT EQUALS AE Y=C SO EXPENDITURE = OUTPUT = INCOME
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ADD THE FINANCIAL SECTOR

HHs CAN SAVE, BY PURCHASING FINANCIAL SECURITIES (ASSETS) FROM THE FINANCIAL SECTOR - I.E., THEY MAKE LOANS TO THE FINANCIAL SECTOR. SAVINGS = PART OF HH INCOME NOT USED TO PAY TAXES OR PURCHASE GOODS AND SERVICES. S = Y - C (WITHOUT GOV'T) SAVINGS IS A FLOW PER PERIOD. THE FLOW OF NET SAVINGS ADDS TO THE STOCK OF WEALTH. DISSAVING = BORROWING 13

EXAMPLE
WEALTH= ASSETS-LIABILITIES THESE ARE ALL STOCKS. E.G. YOU HAVE A HOUSE WORTH RS 200,000 FINANCED BY A MORTGAGE (BANK LOAN) FOR RS 150,000. YOUR EQUITY (WEALTH) ON JAN. 12 IS RS 50,000.

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INVESTMENTS
BUSINESS FIRMS CAN SELL SOME OUTPUT (CAPITAL GOODS) TO OTHER FIRMS, OR ADD IT TO THEIR STOCKS OF INVENTORIES. (FIXED) INVESTMENT: PURCHASES BY FIRMS OF NEWLY PRODUCED CAPITAL GOODS (MACHINERY, EQUIPMENT AND STRUCTURES) INVENTORY INVESTMENT: CHANGES IN THE STOCK OF FINISHED GOODS AND RAW MATERIALS HELD BY FIRMS. FIRMS FINANCE THIS INVESTMENT BY BORROWING FROM THE FINANCIAL SECTOR
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CONSUMPTION AND INVESTMENT

SAVINGS IS A WITHDRAWL OR LEAKAGE FROM THE CIRCULAR FLOW (INCOME WHICH IS NOT USED FOR EXPENDITURE ON OUTPUT) C=Y-S FIXED INVESTMENT IS AN INJECTION TO THE FLOW (EXPENDITURE ON CURRENT OUTPUT WHICH DOES NOT FLOW DIRECTLY FROM THE HH's INCOME) NOW AGGREGATE EXPENDITURE (AE) = C + I AS BEFORE, ALL EXPENDITURE EQUALS THE VALUE OF OUTPUT C+I=Y

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INVENTORY
THIS IS IDENTICALLY TRUE BECAUSE ANY OUTPUT WHICH IS NOT SOLD TO FINAL CONSUMERS OR AS FIXED INVESTMENT IS ADDED TO INVENTORIES. THIS INVENTORY INVESTMENT IS INCLUDED IN OUR DEFINITION OF INVESTMENT. IF CONSUMPTION PLUS FIXED INVESTMENT EXCEEDS THE VALUE OF CURRENT OUTPUT, THE FIRMS SATISFY THE EXCESS BY SELLING PREVIOUSLY PRODUCED GOODS OUT OF THEIR INVENTORIES. THIS NEGATIVE INVENTORY INVESTMENT IS INCLUDED IN OUR DEFINITION OF INVESTMENT 17

OUTPUT AND INCOME

ALL OUTPUT EQUALS ALL INCOME, WHICH CAN BE EITHER CONSUMED OR SAVED Y=C+S SO IT IS IDENTICALLY TRUE THAT IN THIS ECONOMY, SAVINGS EQUALS INVESTMENT: HH SURPLUS = FIRMS DEFICIT C+S=Y=C+I S=Y-C=I S=I HOWEVER, THE ECONOMY IS ONLY IN EQUILIBRIUM WHEN PLANNED EXPENDITURES (C + FIXED INVESTMENT) EQUAL CURRENT OUTPUT, I.E., WHEN UNPLANNED INVENTORY 18 INVESTMENT IS ZERO.

KEYNESIAN MODEL PREVIEW

WHEN PLANNED EXPENDITURE > ACTUAL OUTPUT - INVENTORIES FALL AND FIRMS INCREASE OUTPUT UNTIL EQUILIBRIUM OCCURS WHEN PLANNED EXPENDITURE < ACTUAL OUTPUT - INVENTORIES RISE AND FIRMS DECREASE OUTPUT UNTIL EQUILIBRIUM OCCURS BUT...ACTUAL EXPENDITURE (INCLUDES UNPLANNED INVENTORY CHANGES) IS ALWAYS EQUAL TO ACTUAL OUTPUT AND INCOME!
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ADD THE FOREIGN SECTOR

INDIA HAS BEEN AN OPEN ECONOMY THAT IS IT EXPORTS AND IMPORTS GOODS/ SERVICES (THOUGH VERY LESS AS A PROPORTION OF GDP) THAT IS INDIANS CAN BUY GOODS AND SERVICES FROM THE REST OF THE WORLD (R.O.W.) = IMPORTS (IM), A LEAKAGE FROM THE CIRCULAR FLOW (INCOME WHICH IS NOT SPENT ON THE INDIAN OUTPUT) (SWADESHI?) THE R.O.W. CAN BUY INDIAN OUTPUT = EXPORTS (X), THE EXPORTS ARE TREATED AS AN INJECTION
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The interdependence of goods and factor markets

(3) Factor demand

Rs.
Factor services

Rs.
Goods P P2 P1 D2 D1

(2) Producer supply

P PF2 PF1

D2 D1 O Goods Q1 Q2 Q

QF1 QF2

(4) Factor supply

Factor services

Rs.

Rs.

(1) Consumer 21 demand

 AGGREGATE EXPENDITURE ON INDIAN OUTPUT: AE = C + I + (X - M ) AND, AS BEFORE, ALL DISPOSABLE INCOME IS EITHER CONSUMED OR SAVED: Y=C+S ADD THE GOVERNMENT SECTOR GOVERNMENT CAN PURCHASE OUTPUT = G, AN INJECTION GOVERNMENT CAN SUBTRACT TAXES (TA) FROM INCOMES AND ADD TRANSFERS (TR) TO INCOMES

AGGREGATE EXPENDITURE

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Expenditurecontd
DISPOSABLE (TAKE-HOME) INCOME (YD) IS INCOME (Y) MINUS TAXES PLUS TRANSFERS T = TAXES (TA) MINUS TRANSFERS (TR) YD = Y - T T, NET TAXES, IS A LEAKAGE NOW, AGGREGATE EXPENDITURE AE= C + I + G + (X -M) = OUTPUT = Y = INCOME =C+S+T BECAUSE YD = Y - T AND YD = C + S

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The circular flow of income

INJECTIONS Export Export expenditure (X) expenditure (X) Investment (II ) Investment ( ) Consumption of domestically produced goods and services (Cd) Government Government expenditure (G) expenditure (G) BANKS, etc GOV. ABROAD

Factor payments

Net saving (S)

Net Net taxes (T) taxes (T)

Import Import expenditure (M) expenditure (M)

WITHDRAWALS
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SUMMARY
EXPENDITURE=OUTPUT=INCOME INJECTIONS = I + G + X LEAKAGES = S + T + IM IF I INCLUDES ONLY PLANNED INVESTMENT SPENDING (IP), EQUILIBRIUM OCCURS WHEN INJECTIONS EQUAL LEAKAGES IP + G + X = S + T + M IF I INCLUDES UNPLANNED CHANGES IN INVENTORIES (FORCED ACCUMULATIONS TO/RUNDOWNS FROM EXISTING STOCKS), ALL EXPENDITURE = INCOME IS AN IDENTITY: Y= C + I + G + (X - M)

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SUMMARYcontd
AND: Y = YD + T = C + S + T SO, SUBTRACTING C: I + G + X -M = S + T FUNDAMENTAL MACRO IDENTITY I+G+X=S+T+M REARRANGING: (G - T) + I = S + (M - X) GOV'T BUDGET DEFICIT PLUS PRIVATE INVESTMENT EQUALS PRIVATE SAVINGS PLUS "LOANS" FROM THE ROW.

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LEARNING
1. 2. 3. 4. 5. 6. HOW TO STUDY ECONOMIC TRANSACTIONS BETWEEN SECTORS OF A COUNTRY IN THE FORM OF CIRCULAR FLOW DIFFERENCE BETWEEN FLOWS AND STOCKS SOME POLICY DILEMMAS OPEN AND CLOSED ECONOMIES INJECTIONS AND LEAKAGES MACROECONOMIC IDENTITY DOES THE TOPIC MAKES BUSINESS SENSE? OF COURSE YES. SINCE FORCED INVENTORIES (RUNDOWN AND BUILING UP) IS WHAT THE BUSINESS MUST BE WANTING TO PREVENT. IF THE MACRO LINKAGES ARE WELL UNDERSTOOD, IT CAN HELP IN A GREAT MANNER TO FORECAST WHAT WILL BE THE 27 IMPACT ON INVENTORIES AND CORRESPONDING