MacroEconomics

Preparatory Material
Currenc-I
Important Stats
Parameter Value
GDP $1.85 Trillion
GDP growth rate 5.2% (2
nd
Quarter, 2012)
Contribution to GDP by sector Agriculture 17.2%
Industry 26.4%
Services 56.4%
Inflation rate WPI 7.24% (Nov, 2012)
Exports $300 billion (Dec 2011)
Forex reserves 295.29 billion (Oct, 2012)
Fiscal deficit 5.7% of GDP (FY 12)
Bank rate 9%
CRR 4.25%
SLR 23%
Repo rate 8%
Reverse repo 7%
MSF 9%
Trending Topics
Direct Cash Transfer: Union Governments flagship subsidy transfer
scheme
http://www.dnaindia.com/india/report_fingers-crossed-as-direct-cash-
transfer-scheme-rolls-out_1784497
Foreign Investment Promotion Board (FIPB) clears IKEAs 1.5 billion Euro
investment in to set up its furniture retail chain
http://www.business-standard.com/india/news/ikea-may-enter-indiacut-
down-product-rangenot-without-cafes/496491/
2G spectrum auctions: No takers for 57% of airwaves
http://articles.economictimes.indiatimes.com/2012-12-
12/news/35774073_1_airwaves-mhz-band-upcoming-spectrum-auctions
UPA-II big bang reforms 2012: FDI in retail upto 49%, FDI in insurance
raised to 49%, FDI in aviation
http://www.firstpost.com/business/the-murky-truth-behind-upas-big-bang-
friday-reforms-456864.html
Sahara Vs SEBI: OFCD legal tangle
http://thefirm.moneycontrol.com/story_page.php?autono=792521
Kingfisher airlines row
http://articles.economictimes.indiatimes.com/2013-01-
06/news/36162199_1_lessors-rival-carriers-goair-and-indigo
US fiscal cliff resolution
http://bonds.about.com/od/Issues-in-the-News/a/What-Is-The-Fiscal-
Cliff.htm
Labor dispute pits France against ArcelorMittal
http://www.nytimes.com/2012/11/28/business/global/labor-dispute-pits-
france-against-arcelormittal.html?pagewanted=all&_r=0
Libor fixing scandal Barclays
http://www.economist.com/news/finance-and-economics/21569053-banks-
face-another-punishing-year-fines-and-lawsuits-year-lawyer
National Income Accounting
GDP = C+I+G+NX
Value of all final goods and services produced in the country within a given
period
C Consumption spending ( ~60%)
I Investment spending by businesses and households (~20%)
G Govt purchase of goods and services (~10%)
NX Foreign demand for Net Exports (~10%)
Current India GDP: $1.85 Trillion US dollars

GNP = GDP + Receipts from abroad made as factor payments to
domestically owned factors of production
or GDP + Inflows of factor earnings from abroad (Salaries, Dividends,
Interests on loans) Outflows of factor payments abroad (Salaries, dividends ,
Interest from foreign operations in India)
GNP is monetory value of final goods and services produced by domestically
owned factors of production
Current India GNP: $4.49 Trillion PPP dollars

NDP = GDP Depreciation
Net amount of goods produced in the country in a given period OR
It is the total value of production minus the value of the amount of capital
used up in producing that output

NDP factor cost = NDP IBT + Subsidies
It is the factor income generated in the process of production from economic
activities within the country
IBT = Indirect business taxes like excise duty, VAT etc
Subsidies = They generate factor income as they are used to offset payments
to wages, rents etc

National Income (NI) = NDP factor cost + Net factor earnings from abroad
It is the income earned by domestically owned factors of production
Important points
In India GDP is used for measuring growth rate and in India it is calculated
quarterly
Since GDP captures investments made in the country this is a preferred
measure of growth rate as compared to GNP

IMP LINKS:
Link for important stats:
http://www.indiastat.com/economy/8/nationalincome/175/grossdomesti
cproductgdpnetdomesticproductndp/449275/stats.aspx
World bank stats link :
https://www.google.co.in/publicdata/explore?ds=d5bncppjof8f9_&met_y
=ny_gnp_mktp_pp_cd&idim=country:IND&dl=en&hl=en&q=current%20in
dia%20gnp



Various Economy Models
Simple Economy
Y = C + I (Y Output)
Y = S + C (S Savings)
C + I = S + C

With Govt and Foreign trade
Y = C+I+G+NX
YD= Y+TR-TA (YD- Disposable income, TR Transfer payments, TA Taxes)
YD = C +S
S I = (G+TR-TA) + NX
(S-I) -> Private sector spending
(G+TR-TA) -> Govt budget deficit
NX Net exports
Excess of savings over investment in private sector is equal to sum of budget
deficit and trade surplus

Measuring GDP
Final goods
GDP is taken as the value of final goods and services produced to avoid
double count
Value added
At each stage of the manufacture of a good, only the value added to the good
at that stage is considered for GDP
Eg: Value of bread = value of wheat produced by farmer + (Value of flour sold
by miller value of wheat )
+ (Value of bread sold Value of flour used)
Current Output
GDP consists of value of output currently produced
Imp Points:
Construction of new houses is a part of GDP
Trading of existing houses is not a part of GDP
Value of realtors fees in the sale of existing houses is included in GDP

Inflation and Price Indices
Nominal GDP is GDP evaluated at current market prices. Therefore,
nominal GDP will include all of the changes in market prices that have
occurred during the current year due to inflation or deflation.

Real GDP is GDP evaluated at the market prices of some base year. For
example, if 1990 were chosen as the base year, then real GDP for 1995 is
calculated by taking the quantities of all goods and services purchased in
1995 and multiplying them by their 1990 prices.

Inflation is defined as a rise in the overall price level, and deflation is
defined as a fall in the overall price level.

GDP deflator. Using the statistics on real GDP and nominal GDP, one can
calculate an implicit index of the price level for the year. This index is
called the GDP deflator and is given by the formula



CPI: differs from the GDP deflator in two important ways. First, the CPI
measures only the change in the prices of a basket of goods consumed by a
typical household. Second, the CPI uses base year quantities rather than
current year quantities in calculating the price level index value




Producer Price Index (PPI):It measures the average change over time in the
selling prices received by domestic producers for their output. The prices
included in the PPI are from the first commercial transaction for many
products and some services.

Core inflation represents the long run trend in the price level. In measuring
long run inflation, transitory price changes should be excluded. One way of
accomplishing this is by excluding items frequently subject to volatile prices,
like food and energy

Useful Link: http://www.cliffsnotes.com/study_guide/Nominal-GDP-Real-GDP-
and-Price-Level.topicArticleId-9789,articleId-9734.html

Goods Market Equilibrium, the IS curve
IS curve gives combination of income and interest
at which goods market is in equilibrium ie.,
income or output of the economy equals the
aggregate demand for a given interest rate.
The IS curve is downward sloping because at
lower interest rates investment I is higher. Hence,
output is more at lower income levels.
Increase in income/ spending/ investments
moves IS curve to the right. Decrease moves it to
the left.

A
A
AD
Y
Y
AD1
Y=AD
IS
A
0
-bi
1
i
i
1
Y1
AD2
A
0
-bi
2
Graphical Derivation of IS curve
Y1
B
B
i
2
Y2
Y2
IS curve gives
combination
of income and
interest at
which goods
market is in
equilibrium
AD= (A
0
-bi) + c(1-t)Y
IS Curve
Y = (A
0
- bi) is the IS curve equation. Rewriting,
Interest, i = [A
0
/b] [Y/ (b) ]
Slope of the curve is -1/ (b).
is income multiplier given by 1/ (1 c(1-t) )
b is sensitivity of interest to income changes
Larger the value of , b flatter the IS curve.
Increase in tax rate reduces the multiplier. So
higher the tax rate, steeper the IS curve.
A B
C
A B
Y1 Y0 Y2
AD
Y
i
Y
AD
Y=AD
IS
Ao-bi
(EDG)
AD
Y
(ESG)
AD
Y
C
Points to the left of
the IS curve : excess
demand for goods
(EDG)
Points to the right :
excess supply of
goods (ESG).
Goods market equilibrium
Positions of the IS curve
Money Market Equilibrium, the LM curve
Money supply is determined by the central
bank. M/P= M
0
/P
0
.
M/P = real balances.
Money market equilibrium-The LM curve
LM curve gives the combination of interest and
income at which money market is in
equilibrium. For points along the LM curve,
demand for money = supply of money.

i
L,M/P
i
Y
L1(Y1)
M/P
LM
i1
i2
Y1
Y2
L2(Y2)
Graphical derivation of LM curve
L1, L2 represent demand for money for given income levels



M
0
/P
0
is constant real balances in the
economy (M/P = Real balance)
k,h sensitivity of demand for real balances wrt
income and interest rate respectively.
Slope of the curve is K/h.
This is LM equation
|
|
.
|

\
|
=
0
0
1
P
M
kY
h
i
LM Curve position is determined by level of
M/P.
Increase in M (money supply), increases M/P,
so LM curve moves right.
Increase in P (prices), decreases M/P, so LM
curve moves to the left.
i
L,M/P
i
Y
L(Y1)
M/P
LM
i1
Y1
i2
LM
M/P
M/P
i3
LM
Impact of changes in money supply
Position of the LM curve
i
L,M/P
i
Y
L
M/P
LM
i0
i2
Y1
A
B
C i1
A
B
C
(ESM)
(EDM)
Positions off the LM curve
Md
Ms
Md
Money market equilibrium
Positions off the LM curve

Joint Goods and Money Market Equilibrium

Income, Y
Interest, i
IS0
LM0
Y0
i0
The intersection of the IS and LM graphs gives a unique
combination of interest and income at which both
money market and goods markets are in equilibrium.
IS CURVE
LM CURVE
Liquidity Trap
At very low interest rates, money demand is infinitely
elastic. The LM curve is flat here. People prefer to
hold only cash at this interest rate and no other
asset.
Here monetary policy is ineffective, fiscal policy is
most effective.
Which target for the central bank?
Ultimate tgt. (Goal)
Growth
Inflation
Unemployment
Instruments of
monetary policy
CRR
Repo (disc.) rate
OMO
Intermediate tgt.
Money
Interest
Credit
Exchange rate
Some countries have adopted inflation targets: ECB, New Zealand
Policy Equil. Income Equil. interest rate
Monetry expansion + -
Fiscal expansion + +
IS0
LM0
Y0
r0
LM1
IS1
Crowding Out
Crowding out occurs when an expansionary fiscal
policy leads to rise in interest and results in
reduction in private spending (investment).
Extent of crowding out depends on the slope of
LM curve
Fiscal expansion by tax cut also leads to crowding
out.
Crowding out is minimized when tax cut is
provided for investment I, Investment subsidy, as
this promotes investments.


Classical Case
Classical case is the one with vertical LM
curve.
In classical case, money supply alone
determines level of income and interest rates
are immaterial. ie., Sensitivity of demand in
real balances for decreases in interest rate,
h = 0.
In the classical
case LM curve is
vertical
Fiscal policy is of
no use as there is
complete
crowding out.
Monetary
expansion alone
helps to increase
income.

INTERNATIONAL LINKAGES
Open economy means the economy is open to
exports and imports.
Perfect capital mobility means there is no restriction
on capital flows into and out of the country.
Balance of payments (BOP)
BOP is the record of the transactions of the residents
of a country with the rest of the world.
There are two main accounts in the BoP:
the current account and
the capital account

Balance of payments (BOP)

Current account records trade in goods and services
as well as transfer payments.
Capital account records purchases and sales of assets
such as stocks, bonds and land.
Under fixed exchange rate,
BoP surplus = Current account surplus + net
private capital inflow = increase in official
reserves
Under flexible exchange rate,
current account surplus + net private capital
inflow =0


Terminology
Fixed exchange rate : devaluation, revaluation
Flexible exchange rate : depreciation,
appreciation
Clean float, Dirty (Managed) Float
The real exchange rate is the ratio of foreign to
domestic prices, measured in the same
currency. R = ePf/P.
It measures competitiveness in international trade
In the long run R moves towards PPP of the 2
countries
Imports are a function of our income and R
Exports are a function of our income, foreign
income and R
So, NX = f (Y, Yf, R)
- + +
In fixed exchange rate, money supply is tightly
controlled by BoP. Surpluses imply automatic
monetary expansion, deficits imply monetary
contraction. This is required to maintain the
exchange rate.
In Flexible, the money supply can be set at will
by the central bank.
If Prices are Fixed
International linkages
Internal balance is achieved when Y = Y*
External balance when BoP = 0

BP curve under perfect capital mobility (PCM)




i
Y
BP = 0
BP curve will be flat and is equal
to 0 when i = if
Otherwise, there will be huge
capital inflows (if i>if) or huge
capital outflows (if i<if)
i
BP = 0
Y
i
0
= if
LM
0

IS
0

Y
0

Fixed exchange rate
Commitment to fixed exchange rate requires
intervention from central bank in the forex
market
If BoP is in surplus (deficit), central bank has to
buy(sell) forex. This leads to increase
(decrease) in money supply

i
BP = 0
Y
i
0
= if
LM
0

IS
0

Y
0

LM
1

Monetary policy under fixed exchange rate
International linkages
PCM
E0
E1
i1
No A in Y. Monetary policy is ineffective
Increase in money supply increases real balances
and this moves LM curve to the right.
This lowers the interest rate, followed by huge
capital outflows.
This results in a pressure for devaluation which
the central bank negates by selling foreign
currency and buying local currency from foreign
market.
This means a decreases in money supply as
reserves are depleted. Hence the LM curve
moves back to original position.
Thus, monetary expansion is ineffective.
Vice versa for monetary contraction.

i
BP = 0
Y
i
0
= if
LM
0

IS
0

Y
0

IS
1

LM
1

Y
2

International linkages
Fiscal policy under fixed exchange rate
E0
E2
E1
i1
Y rises. Fiscal policy is effective
Expansionary fiscal policy moves the IS curve
to the right, accompanied by increase in
interest rates.
This causes huge capital inflows and a
pressure for currency revaluation.
To avoid this, central bank buys foreign
currency and sells local currency.
This increases reserves and so moves LM
curve to the right.
Now output is increased as much as possible.
Fiscal policy is most effective.
i
BP = 0
Y
i
0
= if
LM
0

IS
0

Y
0

IS
1

Y
2

Monetary policy under flexible exchange rate
International linkages
E0
E2
E1
i1
LM
1

Monetary policy is effective Y rises
As money supply is increased LM curve moves
to the right which lowers interest rates
capital outflows depreciation of currency.
Depreciation increases competitiveness and
export demand increases. This increases
aggregate demand and so IS curve moves to
the right.
However, currency is now depreciated.
Foreign countries becomes less competitive
now, hence called Beggar thy neighbor Policy
i
BP = 0
Y
i
0
= if
LM
0

IS
0

Y
0

IS
1

International linkages
Fiscal policy under flexible exchange rate
E0
E1
ri
No A in Y. Fiscal policy is ineffective
Fiscal expansion IS curve moves right
Interest rates increase Capital Inflows
exchange rate appreciates.
This decreases competitiveness and export
demand decreases; and so IS curve moves to
the left to its original position.
Now currency has appreciated and income
mix has changed (as NX has reduced and
Y = 0 )
POLICY FIXED EXCHANGE RATE FLOATING
EXCHANGE RATE
Monetary
Expansion
No output change;
reserve losses equal to
money increase
Output expansion,
trade balance
improves, exchange
depreciation
Fiscal Expansion Output expansion, trade
balance worsens
No output change;
reduced net exports;
exchange
appreciation
If Prices are Flexible
Aggregate Demand

Aggregate demand curve gives combinations of
price and output at which the goods market and
money market are in equilibrium.
AD is downward sloping because demand for
goods is higher if price is lower.
Any changes in exogenous variables that
determine shift in the IS (changes in A0)or LM
curve (changes in M0) lead to shift in the AD
curve.
Expansionary fiscal policy and expansionary
monetary policy shift AD to the right.
Restrictive monetary policy and restrictive fiscal
policy shift AD to the left.


Aggregate Supply
AS gives the amount of output firms are willing to
supply at different prices.
AS is upward sloping because firms are willing to
supply more at higher price levels.
SR AS curve is horizontal as prices are sticky
(Keynesian AS curve)
LR AS is vertical as full employment level of
output has been reached (classical AS curve)
How long does it take for AS to change from
horizontal to vertical is a matter of debate.

Growth of Output Over Time, Translated into
Shifts in Aggregate Supply
AD Curve and Medium Run AS Curve
P
AD
Y
P
Y
0

AS
Phillips Curve
Phillips curve gives the inverse relation between
inflation and unemployment. If inflation increases,
(u-u*) decreases
Inflation in prices is synonymous with increase in
wages here
U* is the natural rate of unemployment.
In the final form, Philips curve states that difference
between actual and expected inflation is inversely
related to unemployment level in economy.
t - t
e
= - c (u-u*)
Stagflation is the scenario of high inflation (yet below
expected level of inflation) and high unemployment.
Phillips Curve
One question in P.Curve is why people dont expect the
correct rate of inflation, adjust wages accordingly and
ensure 0 unemployment.
The answer is that people make incorrect expectations
(mostly based on past data) and wages are sticky.
Wages are sticky due to
Labor contracts
Lack of coordination among firms for changing wages
Motivation Theory of Wages : low wages may demotivate
Insider-outsider problem: wage negotiation is always with
people working in your firm and not the unemployed
outsiders
AS Curve from Phillips Curve
AS : P
t+1
=
+1

[1+ (Y-Y*)]
Prices tomorrow will equal expected price
only if economy is in full employment level of
output.
Prices/wages increase if there is surplus
output (due to overemployment)
Supply Shocks
Permanent supply shocks are those that move
the long run AS curve permanently to the right
or left. They could be due to technological
enhancements, newly discovered natural
resources or war, famine etc.,
Temporary supply shocks is a sudden increase
(decrease) in supply of goods. This is
characterized by sudden increase in prices. ie.,
As curve moves up (down).
Supply Shock
Supply Shocks
Due to a temporary supply shock, prices
increase and output Y < Y*. Prices decrease
slowly until AS returns to its original position.
This takes a long time and is recessionary in
nature.
Expansionary monetary policy or fiscal policy
can restore output to Y*, however prices
remain at the high level (P2).
International Linkages
Y*
P
External and Internal Equilibrium

AS
AD
Y
E
NX=0
If a country has BoP
current a/c deficit it is
possible to finance
through reserves,
borrowings/ capital
flows.
But this is not
sustainable for long.
Eventually current a/c
also must balance.
NX is downward sloping because at lower prices export demand is
higher. We assume NX to be steeper than AD. Above NX I trade
deficit, below is trade surplus
Y*
NX=0
AS
AD
P
Y
E
E
Automatic adjustment mechanism

Selling FX reduces, H
and M. AD shifts to
the left.
AS: Unemployment
reduces wages and
prices, AS shifts
down
Equilibrium at E.
If economy is not at equilibrium, AD and AS shift slowly to point of
external and internal equilibrium.
Policies to create employment will typically
worsen trade balance, policies to create a
trade surplus will affect employment.
It is necessary to combine expenditure-
switching policies, which shift the demand
between domestic and imported goods and
expenditure reducing (increasing) policies

Y*
AS
P
Y
NX=0
AD
E
Devaluation Shifts AD and NX schedule
to the right

AD
NX=0
E
Exports increase

In this case one
policy instrument
(devaluation) solves
both the problem of
unemployment and
BoP deficit.

Normal Rule:
As many policy
instruments as there
are policy targets
Devaluation
Devaluation is effective only when foreign price
of domestic goods decreases Real devaluation
If prices increases with devaluation its is of no
effect.
In crawling peg exchange rate, the exchange rate
is depreciated at a rate roughly equal to the
interest rate differential between the country and
its trading partner.
The idea is to maintain R constant by increasing e
at the same rate as P/Pf. R= eP/Pf

Exchange rate and prices: empirical
issues
In small open economies with wage
indexation, it may be difficult to change real
exchange rate through devaluation.
This is because changes in cost of living by
devaluation changes real wages which feeds
into wages. This is the Wage price spiral.
In general countries using devaluation will
have to use restrictive AD policies to ensure
that real exchange rate stays devalued.



Y*
AS
AD1
P
Y
E
Exchange rate and prices: empirical issues
Initial: Y= Y*, NX<0
What policies can correct
BoP problem?
AD
NX=0
Devaln.: NX and AD
rise. If this is combined
with contactionary
policy AD will return to
initial level.
Example:
Deval + Contractionary
monetary policy.
AD= C+I+G+NX

J-Curve and Hysteresis Effect
As NX = X (ePf/P)Q , devaluation initially worsens NX
as volume traded doesnt change immediately. This is
the Price effect.
In the long run, exports start to increase and NX
improves. This is the Volume effect.
This change in NX is characterized by the J-Curve (NX
dips first, rises later)
Hysteresis : If currency was over valued for long time,
people may move to imports, ie. Foreign brands. In this
case, devaluation might take a really long time to bring
any improvement.
For eg. The US $ was over-valued for a really long time
and people in the US had by then accustomed to
cheaper Japanese goods. When $ was devalued,
demand took a long time to move from Japanese to US
goods.
Monetary Approach to BoP
It is suggested (IMF) that BoP imbalance is
monetary phenomenon, can be corrected
through monetary policy changes.
Tight money policy reduces demand, income
and hence BoP deficit can be corrected.
But with sterilization persistent deficits are
possible money stock remains high.

Monetary Approach to BoP
& the IMF
ASSETS LIABILITIES
NET FOREIGN ASSESTS (NFA) HIGH POWERED MONEY (H)
DOMESTIC CREDIT (DC)
CCENTRAL BANK BALANCE SHEET
NFA= H DC
IMF approach involves fixing target : NFA* -based on how
much deficit the country can afford, ability to take external
loans, forex reserves.
Next decide on target for increase in H: H* - this should
be such that it meets the increase in money demand.
The two targets set the limit on domestic credit expansion
DC*
Monetary Approach to BoP
& the IMF
Curtailment of domestic credit reduces demand,
induces recession and corrects the BoP
Proponents of monetary approach argue that
devaluation can not improve BoP except in the
short run
Criticisms of IMF approach:
Countries which are having unemployment will
find it difficult to implement credit contraction.
Adjustment of Exchange Rates and Prices
Y>Y* results in inflation. Y<Y* results in deflation.
i>if appreciation, i<if depreciation of dom. currency.
Monetary Expansion
In the short run, LM moves to the right. Interest
rate is below world level.
Exchange rate depreciates, competitiveness
increases. NX improves and so IS curve moves
right. Short run equilibrium is achieved at E.
In the long run, however, since output is above Y*
prices increase M/P falls LM moves inward.
This increases interest rates currency
appreciates competitiveness is lost restored
to Y*.
Nominal exchange rate appreciates in this
process. Real exchange rate remains the same
Short run and long run effects of
monetary expansion
M/P e P
e
Pf
P

Y
Short run + + 0 + +
Long run 0 + + 0 0
Return on foreign bonds (in terms of domestic
currency) = if + e/e
e is Rs/$ (Rs is home currency here). So if
exchange rate depreciates, e increases and return
on foreign bond is higher.
When capital is completely mobile we expect
interest rates to be equalized, after adjusting for
expected depreciation
Hence, high-inflation countries tend to have high
interest rates and depreciating currencies.
Inflation differential Interest differential
Depreciation rate

i
BP = 0
Y
LM
0

IS
0

Y*
Response to an Expected Appreciation of
Domestic Currency
BP = 0
IS
1

Self-fulfilling expectation
i
f
+

<0
Explanation
If home currency is expected to appreciate, domestic
assets are attractive even at lower interest rate.
Hence, economy achieves BoP = 0 for a lower interest
rate i.
But at the current level, economy is operating in a
surplus and cash flows force the currency to
appreciate.
This reduces competitiveness and forces the IS curve to
move down.
Hence an expectation for appreciation came true, with
appreciation of currency, lowered output and
employment. The expectation is Self fulfilling in nature.

Why governments intervene in FX
markets?
Speculative capital flows may cause unstable
exchange rates and unnecessary changes in
output.
Influence Real exchange rate to affect trade
flows
Effects of exchange rate on domestic inflation
To even out fluctuations in currency
movement not justified by fundamentals
difficult to judge this.

Monetary and fiscal expansion with
interdependence
US Monetary
contraction
US fiscal expansion
US ROW US ROW
Exch. Rate $ Appn. $ Appn.
Output - + + +
Inflation - + - +
All the Best