SESSION 1 -3

1. IN

TRODUCTIO

N TO

MACROECONOMIC

MACROECONOMIC

CONCEPTS

2. KEYNESIAN CROSS

3. IS

LM FR

AMEW

ORK

Centra

l Problems o

f Macro

economics?

�Grow

th (Changes in the

grow

th of Re

al G

DP)

�Busine

ss Cycle

s

�Unemploy

ment

�Infla

tion

�Infla

tion

What is M

acro

economics?

�Micro

economics is the

study of ind

ividual behavio

ur

�The

ory of Firm

, Theory of P

rice Determina

tion o

f a

commodity

�Macro

economics is the

study of a

ggregates

Macro

economics is the

study of a

ggregates

�National Inco

me, O

utput, Em

ploy

ment a

nd General

Price

Level

Basic C

once

pts in M

acro

economics

�Outp

ut / Inco

mes (G

ross D

omestic P

roduct, N

ational

Income)

�Unemploy

ment

�Infla

tion

�Infla

tion

Gross D

omestic P

roduct

�The

total m

arke

t value

of a

ll finalgoods a

nd se

rvices

produce

dwithin a

country

in a give

n periodof tim

e.

�Does no

t include goods tha

t do no

t ente

r the marke

t place

�Does no

t include the

Black Eco

nomy

�Ignores va

lue of le

isure, enviro

nment

�Ignores va

lue of le

isure, enviro

nment

�Related Conce

pts

�Deprecia

tion (G

ross vs. N

et)

�Net Fa

ctor Inco

me fro

m Abroad (D

omestic vs. N

ational)

�Net Ind

irect Ta

xes (M

arke

t Price

vs. Facto

r Cost)

�National Inco

me (N

NP at FC

)

Goods &

Facto

r Marke

ts: Circula

r Flow

Spending

Goods and

services

bought

Revenue

Goods

and services

sold

•Firms sell

•Households buy

MARKETS

FOR

GOODS AND SERVICES

Labor, la

nd,

and capital

Income

= Flow of inputs

and outputs

= Flow of dollars

Factors of

production

Wages, rent,

and profit

FIRMS

•Produce and sell

goods and services

•Hire and use factors

of production

•Buy and consume

goods and services

•Own and sell fa

ctors

of production

HOUSEHOLDS

•Households sell

•Firms buy

MARKETS

FOR

FACTORS OF PRODUCTION

Copyright © 2004 South-Western

Components o

f GDP

�Consum

ption

�Spending

on g

oods &

service

s by ind

ividuals

�Doesn’t includ

e sp

ending

on ho

using

�Inve

stment

�Busine

ss Fixed Inve

stment

�Busine

ss Fixed Inve

stment

�Resid

entia

l Investm

ent

�Additio

n to Inve

ntories

�Governm

ent Ex

penditure

�Spending

by local, sta

te and fe

deral govt.

�Does no

t include tra

nsfer p

ayments (W

HY?)

�Net Ex

ports

Further co

ncepts o

n GDP

�Real vs. N

omina

l GDP

�Nomina

l GDP va

lues the

productio

n of g

oods a

nd se

rvices a

t curre

nt price

s.

�Real G

DP va

lues the

productio

n of g

oods a

nd se

rvices a

t consta

nt price

s.

�Nomina

l GDP ca

n be adjuste

d to Re

ad GDP by using

the GDP

�Nomina

l GDP ca

n be adjuste

d to Re

ad GDP by using

the GDP

deflator (Ra

tio of N

omina

l GDP to Re

al G

DP)

�What is G

rowth?

�Facto

rs that incre

ase productivity

�Physica

l Capital

�Human C

apital

�Natura

l Resource

s

�Techno

logica

l Know

ledge

Questio

n for D

iscussion

�Is G

DP a good measure

of w

ell b

eing

?

�GDP = Gross D

eceptive

Product?

�Is G

rowth e

qual to

Development

Inflation

�Perce

ntage cha

nge in the

price

level fro

m the

previo

us period

�What is the

Price

Level?

�Consum

er P

rice Ind

ex

�Wholesale Price

Index

How

are the

CPI and the

WPI prepared in Ind

ia? W

hich is �How

are the

CPI and the

WPI prepared in Ind

ia? W

hich is better?

�Types o

f Inflation

�Demand Pull

�Cost P

ush

�A rise

in CPI in co

mmensura

te with a

fall in the

rate of

Inflation!

Inflation

�Real vs. N

omina

l Interest Ra

tes

�The

nomina

l interest ra

te is the

interest ra

te usua

lly

reporte

d and no

t corre

cted for infla

tion. It is the

inte

rest ra

te tha

t a bank p

ays.

�The

real inte

rest ra

te is the

nomina

l interest ra

te tha

t is corre

cted for the

effe

cts of infla

tion. It is the

diffe

rence

between the

nomina

l interest ra

te and infla

tion ra

te

�What are the

current le

vels o

f interest ra

tes in Ind

ia?

Unemploy

ment

�Willing

ness to

work b

ut unable to find

a job at the

prevailing

wage ra

te; perce

ntage of la

bourforce

that

is unemploye

d

�Natura

l Rate of U

nemploy

ment: The

amount o

f une

mploy

ment tha

t the economy no

rmally ex

perience

s. une

mploy

ment tha

t the economy no

rmally ex

perience

s. Does no

t go away even in the

long run

�Frictio

nal Unemploy

ment

�Cyclica

l unemploy

mentrefers to

the ye

ar-to

-year

fluctuations in une

mploy

ment a

round

its natura

l rate. It is

asso

ciated with sho

rt-term up

s and dow

ns of the

busine

ss cycle.

Busine

ss Cycle

s

�Upward or D

ownward movement o

f economic a

ctivity

that occurs a

round

a grow

th trend

�All e

conomies g

o thro

ugh a

busine

ss cycle

�Phases of B

usiness C

ycles

�Peak (to

p of the

busine

ss cycle)

�Peak (to

p of the

busine

ss cycle)

�Boom (ve

ry hig

h peak)

�Dow

nturn (falling

from the

peak)

�Recessio

n (decline

in outp

ut that sta

ys fo

r at le

ast 2

conse

cutive quarte

rs)�Depressio

n (large re

cessio

n)�Tro

ugh (B

ottom of re

cessio

n or d

epressio

n)�Upturn o

r Expansio

n (coming

out o

f the tro

ugh!!)

Phases of a

Busine

ss Cycle

Classica

l vs. Keynesians

�Classica

l (Supply cre

ates its ow

n demand)

�Demand for la

bourdepends on re

al w

age ra

te, hence

une

mploy

ment ca

n be reduce

d by re

ducing

the wage

rates

�Keynesia

ns (Demand will cre

ate sup

ply)

�To co

me out o

f depressio

n, increase wage ra

tes =

>

purcha

sing pow

er w

ill increase and people will

demand more goods =

> to meet the

increasing

demand, firm

s will hire

more labour

DETER

MINATIO

N OF IN

COME

AND EM

PLO

YMEN

T

Introductio

n

�One of the

centra

l questio

ns in macro

economics is w

hy outp

ut fluctuates

around

its potentia

l level

�In b

usiness cycle

booms a

nd re

cessio

ns, outp

ut rises a

nd fa

lls relative

to the

trend of p

otentia

l outp

ut

�First the

ory of the

se fluctua

tions in re

al outp

ut relative

to tre

nd

�Mutua

l interactio

n between o

utput a

nd sp

ending

: spending

determine

s outp

ut and inco

me, b

ut outp

ut and inco

me also determine

spending

�The

Keynesian m

odel of inco

me determina

tion d

evelops the

theory of A

D

�Assum

e tha

t price

s do no

t change at a

ll and tha

t firms a

re willing

to

sell a

ny amount o

f outp

ut at the

give

n level of p

rices →

AS curve

is flat

AD and Eq

uilibrium

Outp

ut

�AD is the

total amount o

f goods d

emanded in the

economy:

�Outp

ut is at its e

quilib

rium level w

hen the

quantity

of

outp

ut produce

d is e

qual to

the quantity

demanded, or

NX

GI

CAD

++

+=

NX

GI

CAD

Y+

++

==

�When A

D is no

t equal to

outp

ut there is unp

lanne

d

invento

ry inve

stment o

r disinve

stment, w

here IU is

unplanne

d additio

ns to inve

ntory

�If IU

> 0, firm

s cut back o

n productio

n until outp

ut and AD

are again in e

quilib

rium

NX

GI

CAD

Y+

++

==

AD

YIU

−=

The Consum

ption Functio

n

�Consum

ption is the

largest co

mponent o

f AD

�Consum

ption is no

t consta

nt, but incre

ases w

ith income →

the

relationship

between b

etweenconsum

ption a

nd inco

me is

describ

ed by the

consum

ption functio

n�If C

is consum

ption a

nd Y is inco

me, the

consum

ption functio

n isis

where a

nd

�The

interce

pt of e

quation is the

level of co

nsumption w

hen

income is ze

ro →

this is greater tha

n zero since

there is a

sub

sistence

level of co

nsumption

�The

slope of e

quation is know

n as the

margina

l propensity

to co

nsume (M

PC) →

the incre

ase in co

nsumption p

er unit

increase in inco

me

cY

CC

+=

0>

C1

0<

<c

The Consum

ption Functio

n

[Insert Fig

ure 9-1 he

re]

Equilib

rium Inco

me and Outp

ut

�Equilib

rium occurs w

here

Y=AD, w

hich is illustrated by

the 45°line

in Figure

�The

arrow

s in Figure

show how

the

economy re

ache

s

9-29

the economy re

ache

s equilib

rium

�At any level of o

utput b

elow

Y0 ,

firms’ inve

ntories d

ecline, a

nd

they incre

ase productio

n

�At any level of o

utput a

bove Y

0 , firm

s’ invento

ries incre

ase, a

nd

they decre

ase productio

n

Process continues until r

each Y0

The Fo

rmula

for Eq

uilibrium

Outp

ut

Ac

Y

AcY

Y

)1(

=−

=−

�Ex. If the

MPC = 0.9, the

n 1/(1-

c) = 10 →

an incre

ase in

governm

ent sp

ending

by $1 billio

n results in a

n increase in o

utput b

y

Ac

Y

Ac

Y

)1(

1 )1(

0−

=

=−

results in a

n increase in o

utput b

y

$10 billio

n

�Recip

ients o

f increased

governm

ent sp

ending

increase

their ow

n spending

, the re

cipients

of tha

t spending

increase the

ir spending

and so

on

�MULTIP

LIER IM

PACT!!

Consum

ption a

nd Saving

s

�Inco

me is e

ither sp

ent o

r saved →

a the

ory tha

t explains co

nsumption is e

quiva

lently

explaining

the

behavio

r of sa

ving

�Saving

s function

�Saving

s function

�Saving

is an incre

asing

function o

f the level of

income because

the margina

l propensity

to sa

ve

(MPS) =

1-c is p

ositive

�Saving

s increases a

s income rise

s

The Governm

ent S

ecto

r

�The

governm

ent a

ffects the

level of e

quilib

rium

outp

ut in two ways:

1.Governm

ent ex

penditure

s (component o

f AD)

2.Taxes a

nd tra

nsfers

2.Taxes a

nd tra

nsfers

�Fisca

l policy

is the policy

of the

governm

ent w

ith regards to

G, TR

, and TA

�Assum

e G and TR

are co

nstant, a

nd tha

t there is a

proportio

nal inco

me tax (t)

�The

consum

ption functio

n becomes:

Yt

ccTR

C

tYTR

Yc

CC

)1(

)(

−+

+=

−+

+=

The Governm

ent S

ecto

r

The presence

of the

governm

ent se

ctor fla

ttens the

AD curve

and re

duce

s the multip

lier to

)1(

)1(

AYt

cY

Yt

cA

Y

=−

−

−+

=[]

)1(

1

)1(

1

)1(

0t

c

AY

At

cY

AYt

cY

−−

=

=−

−

=−

−

))1(

1(

1

tc

−−

Multip

lier

The Budget

�The

budget surp

lus is define

d

as:

TR

GtY

BS

−−

≡

9-34

Num

erica

ls

�Suppose total inco

me incre

ases fro

m Rs. 1

000

croresto Rs. 2

000 cro

resand the

total co

nsumption

increases fro

m Rs. 8

00 cro

resto Rs. 1

400 cro

res

what is the

margina

l propensity

to co

nsume?

�Suppose tha

t the margina

l propensity

to co

nsume is

0.8, and inve

stment sp

ending

increases by $100

billio

n. What is the

increase in a

ggregate demand?

Num

erica

ls

�The

consum

ption functio

n for co

untry X is g

iven a

s C

= 50 +0.8Y. Find

out the

equilib

rium level of

aggregate outp

ut if the auto

nomous inve

stment

equals $

100, G

overnm

ent Ex

penditure

equals $

200. The

tax ra

te for the

economy is 2

5%.

200. The

tax ra

te for the

economy is 2

5%.

�Find

out the

Budget surp

lus if transfe

rs equal $ 100.

SESSION 4

SESSION 4

SAVINGS AND IN

VESTM

ENT

INTRODUCTIO

N TO

MONEY

MARKETS

What are Inte

rest Ra

tes?

�Tim

e va

lue of M

oney

�A rup

ee sp

ent to

day is w

orth m

ore tha

n a rup

ee sp

ent

tomorrow

�Unce

rtainty

about future

Tradeoffs b

etween co

nsumption a

nd sa

ving�Tra

deoffs b

etween co

nsumption a

nd sa

ving

�The

ISLM

Model

�Mainta

ins the previo

us discussio

n adding

the inte

rest

rate dimensio

n

�Inve

stments a

re no

t auto

nomous b

ut depend on the

level

of inte

rest ra

tes

The IS Curve

�The

IS curve

shows co

mbina

tions o

f interest ra

tes

and levels o

f outp

ut such that p

lanne

d sp

ending

equals inco

me

�Derive

d in tw

o ste

ps:

1.Link b

etween inte

rest ra

tes a

nd inve

stment

2.Link b

etween inve

stment d

emand and AD

Link between inve

stment d

emand and AD

�Inve

stment is no

longer tre

ated as exo

genous, b

ut dependent up

on

interest ra

tes (e

ndogenous)

�Inve

stment d

emand is low

er the

higher a

re inte

rest ra

tes

�Inte

rest ra

tes a

re the

cost o

f borrow

ing money

�Incre

ased inte

rest ra

tes ra

ise the

price

to firm

s of b

orrow

ing

for ca

pital equip

ment →

reduce

the quantity

of inve

stment

demand

Investm

ent a

nd the

Interest Ra

te

�The

investm

ent sp

ending

functio

n can b

e sp

ecifie

d as:

where b > 0

�i=

rate of inte

rest

b = the

responsive

ness o

f

bi

II

−=

10-40

�b = the

responsive

ness o

f inve

stment sp

ending

to the

interest

rate

�= auto

nomous inve

stment

spending

�Negative

slope reflects

assum

ption tha

t a re

ductio

n in iincre

ases the

quantity

of I

I

The Inte

rest Ra

te and AD: The

IS Curve

All p

oints o

n the IS curve

represent co

mbina

tions o

f iand

income at w

hich the goods

marke

t clears →

goods market

equilibrium sched

ule

10-41

Demand for M

oney

�The

re are 3 motive

s for w

hich money

is demanded

�Tra

nsactio

n

�To ca

rry out d

ay to day tra

nsactio

ns

�Depends p

ositive

ly on the

Level of Inco

me

�Not im

pacte

d by the

interest ra

te (Keynes)

�Not im

pacte

d by the

interest ra

te (Keynes)

�Precautio

nary

�Money

demanded by the

public to

meet unex

pecte

d delay in

receiving

payment o

r unanticip

ated incre

ase in ex

penditure

�Usua

lly club

bed with the

transa

ction d

emand

�Specula

tive

�Inve

rse relationship

between sp

ecula

tive demand and inte

rest ra

te

Specula

tive demand for M

oney

�The

Bond Marke

t�Assum

ption: the

only

alterna

tive to ho

lding

money

is the bond

marke

t

�If yo

u expect b

ond price

s to incre

ase, yo

u buy

�If yo

u expect b

ond price

s to decre

ase, yo

u sell

�Bond is a

n instrument o

n which the

governm

ent is co

mmitte

d to

�Bond is a

n instrument o

n which the

governm

ent is co

mmitte

d to

pay us a

“fixed inte

rest” in a

bsolute

terms, no

t relative

(Disco

unt Rate)

�Price

of the

bond = Re

turn fixed on the

bond / Marke

t rate

of inte

rest

�Inve

rse re

lationship

between inte

rest ra

te and price

of b

ond

�As inte

rest ra

te decre

ase, b

ond price

increase, d

emand for

bonds d

ecre

ase, d

emand for m

oney

increases!

Money

Supply

�Money

supply is a

stock

conce

pt w

hereas G

DP is a

flowconce

pt

�Velocity

of m

oney

is the num

ber o

f times M

oney

excha

nges ha

nd. It is

calcula

ted as the

ratio between G

DP and money

supply

�MV = PY

�What are the

measure

s of m

oney

supply

M1= C + DD

�M1= C + DD

�M3 = C + DD + TD

�M2 = M1 + Po

st Office

Saving

s Deposit

�M4 = M3 + To

tal Po

st Office

Deposits

�Which o

f the above is the

most liq

uid?

�What are Tim

e and Demand Deposits

�Saving

s Acco

unt, Curre

nt Acco

unt and Fix

ed Deposit A

ccount

Equilib

rium Le

vel of Inte

rest Ra

tes

�Money

Demand = Money

Supply

�Money

Supply is C

onsta

nt

�If i>

i*, there is exce

ss supply

of m

oney

; excess m

oney

of m

oney

; excess m

oney

spent o

n buying

bonds; a

s demand for b

onds incre

ases

price

also incre

ases; inte

rest

rates d

ecline

�If i<

i*, there is exce

ss demand for m

oney

; People

sell b

onds; p

rice decre

ases;

interest ra

tes incre

ases

The Money

Marke

t and the

LM Curve

�The

LM curve

shows co

mbina

tions o

f interest ra

tes

and levels o

f outp

ut such that m

oney

demand

equals m

oney

supply →

equilib

rium in the

money

marke

t

�The

LM curve

is derive

d in tw

o ste

ps:

1.Explain w

hy money

demand depends o

n interest ra

tes a

nd

income

2.Equate money

demand with m

oney

supply, a

nd find

combina

tions o

f income and inte

rest ra

tes tha

t mainta

in equilib

rium in the

money

marke

t

Equilib

rium and the

Goods a

nd Money

Marke

t

�The

IS and LM

schedule

s sum

marize

the co

nditio

ns that

have to be sa

tisfied for the

goods a

nd money

marke

ts to

the in e

quilib

riumHow are they b

rought into

[Insert Fig

ure 10-11 he

re]

10-47

�How are they b

rought into

simultaneous equilibrium?

�Assum

ptions:

�Price

level is co

nstant

�Firm

s willing

to sup

ply whatever

amount o

f outp

ut is demanded at

that price

level

Inconsiste

ncy with the

Keynesia

n Model

�When yo

u determine

equilib

rium outp

ut from the

goods m

arke

t, you ne

ed to know

the inte

rest ra

te

from the

money

marke

t

�When yo

u determine

equilib

rium inte

rest ra

te in the

�When yo

u determine

equilib

rium inte

rest ra

te in the

money

marke

t, you ne

ed to know

income fro

m the

goods m

arke

t

�Hence, w

e use

simulta

neous d

etermina

tion o

f income

and inte

rest ra

tes fro

m the

ISLM

framew

ork

Fiscal and Monetary Po

licy

�Expansio

nary Fisca

l Policy

�Moves the

IS curve

to the

right

�Outp

ut increases, inte

rest ra

te incre

ases

�Contra

ctionary

Fiscal Po

licy�Moves the

IS curve

to the

left

Outp

ut decre

ases, inte

rest ra

te decre

ases

�Outp

ut decre

ases, inte

rest ra

te decre

ases

�Expansio

nary Monetary Po

licy�Moves the

LM curve

to the

right

�Outp

ut increases, inte

rest ra

te decre

ases

�Contra

ctionary

Monetary Po

licy�Moves the

LM curve

to the

left

�Outp

ut decre

ases, inte

rest ra

te incre

ases

Instruments o

f Fiscal Po

licy

�Incre

ase in G

overnm

ent

Expenditure

�Incre

ase in inco

me is le

ss tha

n the Keynesia

n multip

lier

�Due to fisca

l policy

�Due to fisca

l policy

expansio

n, interest ra

tes

increase and priva

te

investm

ent re

duce

s�Hence

there is

CROWDING OUT

�In this tra

nsmissio

n mecha

nism, adjustm

ents

happen a

long the

LM curve

Instruments o

f Monetary Po

licy

�Reserve

Ratios

�Cash re

serve

Ratio

�Statuto

ry Liq

uidity Ra

tio

�Policy

Rates

Repo Ra

te�Repo Ra

te

�Reverse

Repo Ra

te

�Bank Ra

te

�Prim

e Le

nding

Rate

�Saving

s Deposit Ra

tes

�Fixe

d Deposit Ra

tes

Reserve

Ratios

�Proportio

n of the

deposits tha

t the co

mmercia

l bank

has to

keep with the

RBI is the

Cash Reserve Ratio

�Inve

rse relationship

between C

RR and Money

Supply

�Proportio

n of d

eposits tha

t the co

mmercia

l bank ha

s �Proportio

n of d

eposits tha

t the co

mmercia

l bank ha

s to ke

ep in g

overnm

ent se

curities is the

Statutory

Liquidity Ratio

�Inve

rse relationship

between S

LR and Money

Supply

Policy

Rates

�The

rate at w

hich Commercia

l Banks b

orrow

from

the RBI to

meet its lo

ng term liq

uidity ne

eds is the

Bank Rate

�The

rate at w

hich Commercia

l banks b

orrow

from

the RBI to

meet its sho

rt term liq

uidity ne

eds in the

the

RBI to

meet its sho

rt term liq

uidity ne

eds in the

Repo Rate

�The

rate at w

hich Commercia

l banks le

nd to the

RBI

for sho

rt term is the

Reverse Repo Rate

�Inve

rse Re

lationship

between Po

licy Ra

tes a

nd

Money

Supply