Introduction to Macro Economics

Important Issues in Macroeconomics

Macroeconomics, the study of the economy as a
whole, addresses many topical issues:
•

• Why does the cost of living keep rising?

• Why are millions of people unemployed, even when the
economy is booming?
• What causes recessions?
• Can the government do anything to combat recessions?
Should it?
• What is the government budget deficit? How does it
affect the economy?
• Why are so many countries poor? What policies might
help them grow out of poverty?
 Macroeconomics vs. Microeconomics
• Microeconomics
•

• Decisions of individual units

•

• No matter how large

• Example: GE’s pricing policy
• Macroeconomics
•

• Behavior of entire economies

•

• No matter how small

• Example: Onion inflation
• Economic aggregates: aggregate output,
inflation, unemployment, …
 Macroeconomics & Aggregation
• Aggregation
•

• Combine many individual markets into one

overall market
• Why can we aggregate?
•

• Composition of demand & supply

•

• In various markets
• Important for microeconomics issues
• Not important for macroeconomics issues
• During economic fluctuations, markets
move up or down together
 Macroeconomics & Microeconomics
• Macroeconomics
•

• Assume most details

•

• Resource allocation & income distribution

• Relatively unimportant
• Microeconomics
•

• Ignore macroeconomics issues

• Focus – individual markets
•

• Allocate resources
• Distribute income
 Supply & Demand in Macroeconomics
• Aggregate demand (AD)
AD curve
•

• Quantity of domestic product – demanded

• Each possible value of price level
• Aggregate supply (AS)
AS curve
•

• Quantity of domestic product – supplied

• Each possible value of price level
 Figure 1
Two interpretations of a shift in the demand curve

S S
D1
D D0 A
P1
E P E
P
ri P0 ri P0
c c
e e

S S
D1
D D0
0 Q0 0

Quantity Quantity

(a) (b)
 Supply & Demand in Macroeconomics
• Inflation
•

• Sustained increase in price level

• Outward shift of aggregate demand curve
• Recession – period of time
•

• Total output – declines

•

• Production falls
• People lose jobs
• Inward shift of aggregate demand curve
Figure 2
An economy slipping into a recession
S
D0

D2 E
P0
B
P2

P
ri
c S D0
e D2
L
e 0 Q2 Q0
v
el
Domestic Product
 Supply & Demand in Macroeconomics
• Macroeconomists study
•

• Inflation
• Recession & unemployment (Business
Cycles)
• Economic growth
Figure 3
Economic growth
S0
D1 S1
D0

D1
P
ri
c S0 D0
S1
e
L
e 0 Q0 Q1
v
el
Domestic Product
 Gross Domestic Product
• Gross domestic product (GDP)
•

• Sum: money values

• All final goods & services
•

• Produced - domestic economy (Toyota car

produced in the US vs. Ford pick-up produced in
Japan)
• Sold – organized markets (gambling in Vegas vs.
gambling in Chicago)
• Specified period of time
•

• Usually a year
 Gross Domestic Product
• Nominal GDP
•

• GDP in current dollars

• Value outputs – current prices
• Real GDP
•

• Value outputs of different years at common

prices
• GDP in constant dollars
 What Gets Counted in GDP?
• GDP - particular year
•

• Add up money value of things

• Goods & services
•

• Produced within the year

• Final goods & services
• Production: geographic boundaries of U.S.
• Organized markets
 Gross Domestic Product
• Final goods and services
•

• Purchased by their ultimate users

• Intermediate good - purchased
•

• For resale
• For use in producing another good
 Gross Domestic Product
• Limitations of GDP
•

• Not measure: nation’s economic well-being

• Includes only market activity
•

• Housework, yard work, …

• Places no value on leisure
• Counted: “Bads” and “Goods”
•

• Hurricane Katrina might increase GDP

• Ecological costs
•

• Not deducted from GDP

• Needed: “Green GDP”
Circular Flow of Economic Activities and
Income
The simple model of the circular flow assumes two players
Firms
• Produce and supply the goods and services.
• Require various factors of production to produce these goods and services.
Households
• Include a set of individuals living in the same house
• Take joint decision about the consumption of goods and services.
• Provide services in terms of factor inputs to the firms
• Get paid for these services by firms which households spend on
consumption.
•
Money flows from firms to households as factor payments and from
households to firms as expenditure on goods and services.
•
It is a circular flow of money or income
Circular Flow of Income(Two Sector
Economy)
(Wages, Rent, Interest and Profits)
Factor Payments
(Y)

In the equilibrium Y=E=O

 Circular Flow of Economic Activities
and Income
•
Value of output produced (Y) = value of output sold (O)
•
Value of output sold = Sum of consumption expenditure (C) and
investment expenditure (I).
Y=O=C+I=E……(1)
• Income is either consumed or saved (S).
Y=C+S………….(2)
C+I=Y=C+S………(3)
• Therefore: I = S…………(4)
•
Savings are withdrawal of money from the circular flow
• Investment is injection of money into the circular flow
•
For equilibrium savings should be equal to investments
•
Hence Y=O=E
 Circular Flow of Income(Four Sector
Economy)

The third sector is Government (G)

• Government Spending
•

• On provision of public utility goods and services.

• Provides salaries to the households
• Pays to firms for purchases of goods and services
• Government Revenue
•

• Households and firms pay various taxes and other payments and provide factor
inputs to the government.
• Government borrows from the financial market to fill revenue gap.
The fourth sector is the external sector
• Imports (M): Outflow of income occurs when the domestic firms buy goods
and services from foreign ones.
• Exports (X): Inflow of income takes place when foreign firms buy goods and
services from domestic ones
Circular Flow of Income(Four Sector
Economy)

Remittances
Taxes Taxes for purchases
Salaries

Exports Exports
Consumption Government
Expenditure (G)

Imports Imports
 Circular Flow of Income(Four Sector
Economy)
• National income includes expenditures on consumption investment,
government and net of exports (X-M)
National Income=C+I+G+(X-M)
• Since national income can either be consumed, or saved, or paid as tax to
the government:
C+I+G+(X-M)=C+S+T
I+G+(X-M) =S+T
• Sum of private investment and expenditure on net exports is equal to the
sum of savings and tax revenue. Thus:
I+G+X =S+T+M
• Therefore, W=J
• At equilibrium, total injections are equal to total withdrawals.
 Macro-economic Variables

• Aggregate Demand and Aggregate Supply

•

• Aggregate Demand is the sum of demand for all goods and services
by all the consumers for a given period of time.
•

• aggregate demand (AD) for consumer goods i.e. consumption

demand (C)
• aggregate demand for capital goods i.e. (I).
Thus AD = C+I
• Aggregate supply is the total national output produced and supplied by all
the factors of production in an economy.
• It refers to the supply of all goods and services in the economy for a given
period of time.
• Aggregate supply (AS) consists of
•

• supply of consumer goods (C) and

• Supply capital goods (where capital comes from savings (S),
Hence AS=C+S
 Macro-economic Variables

• Stock and Flow

•

• 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 increase (inflows) and decrease
(outflows) the stock, over a period of time.
•

• like income, consumption, saving and investment

Stock=Inflows-Outflows
• Intermediate and Final Goods
•

• Intermediate goods (and services) are items purchased by firms for

using them in production of some other good of utility.
 Macro-economic Variables

• Capital formation
•

• The process of savings being converted into investment is known as capital

formation
• Gross Capital Formation refers to the aggregate of additions to fixed assets
(Fixed Capital Formation) and increase in stocks of inventories during a period of
time.
• Employment
•

• An employed person is willing and capable to work in a productive activity and is

engaged for certain number of hours per week, whether working for self or
someone else.
• The population of any country is divided into working population (age group of 16
to 65 ) and dependents.
• Government Expenditure and Revenue
•

• Government Expenditure is which is made from public exchequer.

• Government Revenue is income received by government in various forms, e.g.
 National Income
• National income is defined as the money value of all the final
goods and services produced in an economy during an
accounting period of time, generally one year.
Concepts of National Income
• Gross Domestic Product (GDP)
• Gross National Product (GNP)
• Net Domestic Product (NDP)
• Net National Product (NNP)
• Per Capita Income
 Gross Domestic Product
• 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.
GDP= C+I+G+(X-M)
• GDP at market price: includes the final value of goods and
services also includes indirect taxes and excludes the subsidies
given by the government.
• GDP at factor cost is the money value of final goods and
services based on the cost involved in the process of
production.
Gross Domestic Product at factor cost
= GDP at Market Prices –Indirect Taxes+ Subsidies
 Gross National Product

• Gross National Product (GNP): GNP is the aggregate final

output of citizens and businesses of an economy in a year.
• GNP may be defined as the sum of Gross Domestic Product
and Net Factor Income from Abroad (NFIA).
GNP = GDP + NFIA
GNP = C+I+G+(X-M)+NFIA
•

• Net Factor Income from Abroad: 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.
 Net Domestic Product and Net
National Product
• Net Domestic Product
•

= GDP-Depreciation
• Net National Product (NNP)
= GDP–Depreciation +NFIA
Or =GNP–Depreciation
• Thus NNP is the actual addition to a year’s wealth and is the sum of
consumption expenditure, government expenditure, net foreign expenditure,
and investment, less depreciation, plus net income earned from abroad.
= C+I+G+(X–M)–Depreciation + NFIA
• NNP at Factor Cost is the sum total of income earned by all the people of the
nation, within the national boundaries or abroad
• It is also called National Income.
• NNP at Factor Cost = NNP at Market Prices –Indirect Taxes+ Subsidies
 Real and Nominal National
Income
• National income estimated at the prevailing prices, is called national income
at current prices or Nominal National Income, or Money National Income
or national income at current prices.
• National income measured on the basis of some fixed price, say price
prevailing at a particular point of time, or by taking a base year, is known as
national income at constant prices, or Real National Income or national
income at constant prices.

Nominal GDP
Real GDP =
GDP deflator

GDP deflator is the ratio of nominal GDP in a year to real GDP of that year
GDP deflator measures the change in prices between the base year and the current
year.
 Per Capital Income and Personal
Income
Per capita income is the average income of the people of a country in a particular
year.

National Income
Per Capita Income =
Total Population

• Personal income is the total income received by the individuals

of a country from all sources before direct taxes in one year.
Personal Income = National Income –Undistributed Corporate Profits –
Corporate Taxes – Social Security Contributions + Transfer Payments +
Interest on Public Debt
• Personal Disposable Income is the income which can be spent on
consumption by individuals and families.
Personal Disposable Income = Personal Income – Personal Taxes
 GDP Deflator
• The GDP price deflator measures the changes in prices for all
goods and services produced in an economy.
• Using the GDP deflator helps economists compare the levels of
real economic activity from one year to another.
• Without the GDP deflator, comparing GDP from two different
years would yield a deceptive result if prices changed during the
two years.
• GDP Price Deflator=(Nominal GDP÷Real GDP)×100
• Present: Base Year For GDP (2017-18), Inflation
Calculation (2018)
• Proposed: Base Year For GDP (2017-18), Inflation
Calculation (2018)
 Methods of measuring national
income
• In equilibrium
Output=Income=expenditure
• Hence there are three approaches to the measurement of
GDP:
• Product (or Output) Method: National Income by Industry
of Origin
•

• Final Product Method

• Value Added Method
• Income Method or National Income by Distributive Shares
• Expenditure Method
 Product (or Output) Method

• The market value of all the goods and services produced in the
country by all the firms across all industries are added up
together.
• Process
•

• The economy is divided on basis of industries, such as agriculture, fishing,

mining and quarrying, large scale manufacturing, small scale
manufacturing, electricity, gas, etc.
• The physical units of output are interpreted in money terms
• The total values added up. (GDP at market price)
• The indirect taxes are subtracted and the subsidies are added. (GDP at
factor cost)
• Net value is calculated by subtracting depreciation from the total value
(NDP at factor cost).
 Limitations of Product Method

• Problem of Double Counting:

•

• unclear distinction between a final and an intermediate

product.
• Not Applicable to Tertiary Sector:
•

• This method is useful only when output can be measured

in physical terms
• Exclusion of Non Marketed Products
•

• E.g. outcome of hobby or self consumption

• Self Consumption of Output
•
 Income Method

• The net income received by all citizens of a country in a particular year, i.e.
total of net rents, net wages, net interest and net profits. (GDP at factor cost).
•
It is the income earned by the factors of production of a country.
• Add the money sent by the citizens of the nation from abroad and deduct the
payments made to foreign nationals (individuals and firms) (GNP at factor
cost) or Gross National Income (GNI).
Process:
•

•
Economy is divided on basis of income groups, such as wage/salary
earners, rent earners, profit earners etc.
•
Income of all the gruops is added, including income from abroad and
undistributed profits.
• The income earned by foreigners and transfer payments made in the year
are subtracted.
GNI = Rent + Wage + Interest +Profit + Net Income from Abroad- Transfer
payments
 Limitations of Income Method

• Exclusion of non monetary income: Ignores the non-

monetized section of economic activities.
•

• Economic activities that contribute to national income, but due to their

non monetary nature, they go unrecorded. For e.g. a farmer and family
working in their own field.
• Exclusion of Non Marketed Services: People undertake a
particular activity that are difficult to ascertain in money value.
E.g. mother’s services to the family.
 Expenditure Method of Measuring National
Income

• The total expenditure incurred by the society in a particular

year is added together to get that year’s national income.
• Components of Expenditure:
•

• personal consumption expenditure

• net domestic investment
• government expenditure on goods and services, and
• net foreign investment
Limitations
• Ignores Barter System
• Ignores Own Consumption
• Affected by Inflation
 Uses of National Income Data

• National income is the most dependable indicator of a

country’s economic health.
• Difference between GDP and GNP indicates the contribution
of net income earned abroad
• Necessary for Economic planning: useful aid in judging
which sectors should be given more emphasis
• A measure of economic welfare.
•

• higher aggregate production implies more and more goods and services
being available to people
• Helps in determining the regional disparities, income
inequality and level of poverty in a country.
• Helps in comparing the situations of economic growth in two
different countries.
 Difficulties in Measurement of National
Income
• Non monetized transactions: Exchange of goods and services which have
no monetary payments, like services rendered out of love, courtesy or
kindness are difficult to include in the computation of national income.
• Unorganized sector: Contribution of unorganized sector are unrecorded. It
is very difficult to identify income of those who do not pay income tax.
• Multiple sources of earnings: Part time activity goes unrecognized and
such income is not included in national income.
• Categorization of goods and services: In many cases categorization of
goods and services as intermediate and final product is not very clear.
• Inadequate data: Lack of adequate and reliable data is a major hurdle to
the measurement of national income of underdeveloped countries.