Macro Economics All 1

8/9/2019 Macro Economics All 1

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MACRO ECONOMICSDR. P. RAVILOCHANAN


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STOCKS AND FLOWS

STOCK Measured at a specified point of time Long run concept[Example : Total number of persons employed, balance sheet of acompany, money supply, price level, consumer priceindex, unemployment level, foreign exchange reserves ] FLOW Measured for a specified period of time Short run concept

[Example : Number of persons who got new jobs, profit and lossaccount of a company, Gross domestic product,

inflation, exports, imports, wages, taxes, consumption,investment] Flows have a direct counterpart stock variables.However, some flow variables may not have direct stock variables.

Stock and flow are interdependent, that one affects the other [Example : Capital stock and investment]


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REAL GNP AND NOMINAL GNP

Real implies that the data have been adjusted for changes inthe level of prices

Over time, nominal values reflect changes both inA] real size of an economic variable andB] the general level of prices

Over time, real values eliminate the impact of changes in pricelevel

REAL GNP [Current year] =Price index of Base year

Nominal GNP current year X -----------------------------------------Price index of Current year


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RATE OF GROWTH

Growth rate is the indicator of the performance of a countryTwo types of growth rate :a] Growth rate of Gross Domestic Product [in real terms]

b] Growth rate of Percapita Gross Domestic Product indicates improvement in standard of living. Calculatedafter determining the growth rate of population [p]

So, Percapita GDP = [GDP growth rate [g%] / Populationgrowth rate] - 1

[ 1 + g% / 1 + p%] - 1


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CIRCULAR FLOW OF INCOME - TWO SECTOR

MODEL

SUPPLY OF GOODS & SERVICES

FACTOR INCOME

HOUSEHOLD BUSINESS

SECTOR SECTOR FACTOR SERVICES

DEMAND FOR GOODS & SERVICES

MIC 1


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CIRCULAR FLOW OF INCOME 3 SECTOR MODEL

GOVERNMENT SECTOR

SAVINGCAPITAL MARKET

INVESTMENT

HOUSEHOLD SECTOR BUSINESS SECTOR

TAXESGOVT. EXPENDITURE

MIC 2


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CIRCULAR FLOW OF INCOME 4 SECTOR MODEL

GOVERNMENT SECTOR

SAVING CAPITAL MARKET INVESTMENT

HOUSEHOLD SECTOR BUSINESS SECTOR

TAXESGOVT. EXPENDITURE

EXPORTSIMPORTS


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PRODUCTION POSSIBILITY CURVE

GUNS

BUTTE

R


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M


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PERSONAL


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METHODS OF MEASURING NATIONAL INCOME

1. OUTPUT METHOD [VALUE ADDED METHOD]

OUTPUT OF AGRICULTURE & EXTRACTIVE INDUSTRIES+OUTPUT OF MANUFACTURING INDUTRIES

+OUTPUT OF SERVICES & CONSTRUCTION

=

GROSS DOMESTIC PRODUCT AT FACTOR COST+

NET FACTOR INCOME FROM ABROAD[INCOME RECEIVED INCOME PAID ABROAD]

=GROSS NATIONAL PRODUCT AT FACTOR COST

-CAPITAL CONSUMPTION OR DEPRECIATION

=NET NATIONAL PRODUCT AT FACTOR COST OR

NATIONAL INCOME


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EXPENDITURE METHOD

C + I + G = GROSS DOMESTIC EXPENDTIURE

+

[E I]

=

GROSS NATIONAL PRODUCT AT MARKET PRICES

-INDIRECT TAXES

+ SUBSIDIES

=

GROSS NATIONAL PRODUCT AT FACTOR COST


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METHODS OF MEASURING NATIONAL INCOME

3. INCOME METHOD

INCOME FROM EMPLOYMENT+

INCOME FROM SELF-EMPLOYMENT+

GROSS TRADING PROFITS OF COMPAIES+

GROSS TRADING SURPLUS OF PUBLIC CORPORATIONS+

RENT=

GROSS DOMESTIC PRODUCT AT FACTOR COST

+NET FACTOR INCOME FROM ABROAD=

GROSS NATIONAL PRODUCT AT FACTOR COST


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DIFFICULTIINCOME


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SYSTEM OF SOCIAL ACCOUNTING

PRODUCTION ACCOUNT [BUSINESS SECTOR]

EXPENDITURE REVENUEFactor incomes

A) Paid to Domesticresidents

Sales to Households

B) Paid to Foreign residents Sales to Government

Retained profits Domestic Investment

Corporate profit tax a) Fixed investment

Indirect tax b) Inventory investment

Imports Exports

Depreciation Subsidies fromGovernment


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EXPENDITURE INCOME

CONSUMPTION INCOMES FROMDOMESTIC PRODUCTION

PERSONAL INCOME TAX INCOME FROM ABROAD

TRANSFERS TOFOREIGNERS

TRANSFERS FROMGOVERNMENT

PERSONAL SAVINGS TRANSFERS FROMFOREIGNERS

HOUSE HOLD SECTOR


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GOVERNMENT ACCOUNT

EXPENDITURE REVENUE

WAGES & SALARIES CORPORATE PROFIT TAX

PURCHASES OF GOODS &

SERVICES

INDIRECT TAXES

TRANSFERS TOFOREIGNERS

PERSONAL INCOME TAX

TRANSFERS TOHOUSEHOLDS

SUBSIDIES TOPRODUCERS

SURPLUS DEFICIT


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SAVINGS INVESTMENT ACCOUNT

SAVINGS INVESTMENT

PERSONAL SAVINGS FIXED INVESTMENT

BUSINESS SAVINGS NET CHANGE INSTOCK

GOVERNMENT SAVINGS

DEFICIT ON CURRENTACCOUNT

SURPLUS ON CURRENTACCOUNT


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-KEYNISIAN ECONOMICSEFFECTIVE DEMAND = OUTPUT = INCOME = EMPLOYMENT

AGGREGATE SUPPLY FUNCTION AGGREGATE DEMAND FUNCTION

CONSUMPTION INVESTMENT GOVERNMENT EXPENDITURE

SIZE OF INCOME PROPENSITY TO CONSUME

MARGINAL EFFICIENCY OF CAPITAL RATE OF INTEREST

SUPPLY PRICE OF CAPITAL PROSPECTIVE YIELD

TRANSACTION PRECAUTIONARY SPECULATIVEMOTIVE MOTIVE MOTIVE


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CONSUMPTION FUNCTION (1)

Consumption function explains the relationship between Income[Y] and Consumption [C]

So, C = f ( Y)

Keynes Psychological law of Consumption :

When Y increases C also increases at a lesser rate

When Y decreases C also decreases at a lesser rate

INCOME [Y] : 100 150 200 250 300 350CHANGE IN Y (50) (50) (50) (50) (50)

CONSUMPTION [C] : 100 145 190 230 250 260CHANGE IN C (45) (45) (40) (20) (10)


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a

Y

C

INCOME [Y]

CONSUMPTION

[C]

MPC = C / Y

C

b


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Keynes equation : Y = C + SY = C + I

So, S I

Marginal Propensity to Consume [MPC]The extent of change in consumption[C] for a change inincome [Y] MPC = C / Y

Marginal Propensity to Save [MPS]The extent of change in Saving [S] for a change inincome [Y] MPS = S / Y


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From Keynes basic equation :

Y = C + S

So C = Y - S

And S = Y - C

Therefore MPC + MPS = 1

MPC = 1 - MPS

MPS = 1 - MPC

Ex : Suppose income increases from Rs. 100 to Rs. 120 andConsumption expenditure goes up from Rs. 75 to Rs. 90

Then MPC = 15 / 20 = 0.75

and MPS = 1 - 0.75 = 0.25


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Determinants of Consumption Function :A] Subjective factors :

i ) Individual motives ii) Business motives- Desire to hold reserves for - Desire to do big things

contingencies - Liquidity maintenance- Reserves for future needs - Increase income and- Desire to get large interest provide for reserves

return - To discharge debts- Improve standard of living- A sense of security- To bequeath wealth- Miserliness


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Determinants of Consumption Function :B] Objective Factors

Change in Wage level Windfall gains / losses Changes in Fiscal policy Change in expectations Change in rate of interest Financial policies of Corporations Holding liquid assets Distribution of income Change in attitude Demonstration effect


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LONG RUN CONSUMPTION FUNCTION IN A STEADYSTATE

Ct = a + b Ytd + gCt 1

Where : Ct = Consumption expenditure for the current period

a = Autonomous consumption

b = Short run MPC

Ytd = Disposable personal income for the current period

g = Coefficient indicating the relation between current periodconsumption and previous period consumptions

C t 1 = Previous period consumption expenditure


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INVESTMENT MULTIPLIER (8)

Multiplier [ki] explains the relationship between additional

investment and additional income. That is, when there isadditional investment, it will lead to increase in income. Thequantum of increase income for an increase in investment ismeasured to determine the multiplier.

The value of multiplier depends on the value of MarginalPropensity to Consume [MPC]

k = (1/ 1- MPC) or 1 / MPS(as MPS = 1 - MPC)


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C+I

Y1 Y Y2 (Y)

Y = CC + I

CI


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Example : Additional investment is Rs. 100 crores andMPC = 0.8. Calculate multiplier and the increase in

income.

Using MPC : k = 1/ 1 0.8 = 1 / 0.2 = 5

Increase in income = k . Additional investment= 0.5 . 100 = Rs. 500 crores

If MPC in the above example is 0.6, then k = 2.5 and incomegenerated would be only Rs. 250 crores

GREATER THE MPC, GREATER WOULD BE THEINCOME GENERATED AND LESSER THE MPC,LESSER WOULD BE THE INCOME GENERATED


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BALANCED BUDGET MULTIPLIER Balanced budget means that revenue and expenditure of the

government would be equal. Hence, whenever a tax is imposed,

there would be reduction in consumption, but this isneutralized by increasing public expenditure to the extent of

the tax amount. However, when tax is imposed, the level of

disposable income is reduced which is used for consumption

purpose. Hence, the economys consumption expenditurewould not fall by the full amount of tax.


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Govt. expenditure multiplier = Y = [1 / 1 c ] x G[ Y / G] = 1 / 1 - c

This shows that change in income will equal the multiplier times thechanges in autonomous government expenditure

Tax multiplier is = Y = [ - c T ] / 1 c= Y / T = - c / 1 - c

This shows that the change in income will equal multiplier times theproduct of the MPC and change in taxes.

Suppose there is a simultaneous change in tax and public expenditure[i.e., to ensure that the budget in balance]


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Suppose there is a simultaneous change in tax and public expenditure[i.e., to ensure that the budget in balance]

[ Y / G ] + [ Y / T] = [ 1/ 1-c ] [c / 1 c] = [1 c] / [1 c] =1

Example : Suppose MPC = 0.67, G = T = 10

Government expenditure multiplier =[1 / 1- c] = [1 / 1 0.67] = 1/ 0.33 = 3

Tax multiplier = [- c / 1 c ] = - 0.67 / 1 0.67= - 0.67 / 0.33 = 2

Therefore the increase in income due to the combined effect of taxand public expenditure =

Y = [3 x G - 2 T ] = 3 x 10 2 x 10 = 10


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In an open economy, Investment is divided as :

Domestic investment Id and Foreign

investment If I = S

I d + I f = S

Foreign investment = I f = X - MSo Id + X - M = S [or]

Id + X = S + M


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Foreign trade multiplier co-efficient[ kf] = Y / X and X = S + MDividing both sides by Y X / Y = ( S + M ) / Y1 / kf = ( S + M ) / Y

or kf = Y / ( S + M ) Dividing by Y

Therefore kf = 1 / ( S / Y ) + ( M / Y]= 1 / MPS + MPI

PRINCIPLOE OF ACCELERATOR


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PRINCIPLOE OF ACCELERATOR

A PROCESS BY WHICH AN INCREASE [OR] DECREASE INTHE DEMAND FOR CONSUMPTION GOODS LEADS TO

AN INCREASE [OR]DECREASE IN INVESTMENT ONCAPITAL GOODS

ACCELERATION COEFFICIENT

= I / C I = C

- is accelerator coefficient

C is the net change in consumption expenditure I is the net change in investment

Ex: If the C increases by Rs. 10 crores and investment increases

by Rs. 30 crores, then is 30/10 = 3

ACCELERATION PRINCIPLE


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PERIOD TOTALOUTPUT

Y

REQUIREDCAPITAL

v=4(Req. cap = vY)

REPLACEMENTINVESTMENT

R

NETINVESTMENT

I n

GROSSINVESTMENT[I g= I n+ R]

t 100 400 40 0 40

t+1 100 400 40 0 40

t+2 105 420 40 20 60

t+3 115 460 40 40 80

t+4 130 520 40 60 100

t+5 144 560 40 40 80

t+6 145 580 40 20 60

t+7 140 560 40 - 20 20

t+8 130 520 40 - 40 0

t+9 125 600 40 - 20 20

ACCELERATION PRINCIPLE


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Therefore Accelerator is ratio of induced investment tochanges in output it calls forth.

v = I / YGross investment [I gt = v(Y t Y t-1 ) + R

= v Y t + R

Where I gt is gross investment in period tY t is the national output in period t

Y t-1 is the national output in the previous

period [t-1]R is the replacement investment


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To get net investment I n R must be deducted from both sides of the equation so that the net

investment in period t isInt = v(Y t Y t-1 )

= v Y tIn other words, this is the same as v = I / Y

Since Y = Y t Y t-1

Accelerator v and are one and the same


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ASSUMPTIONS OF ACCELERATION PRINCIPLE

1. A CONSTANT CAPITAL OUTPUT RATIO2. RESOURCES ARE EASILY AVAILABLE3. THERE IS NO EXCESS OR IDLE CAPACITY IN PLANTS4. THERE IS ELASTIC SUPPLY OF CREDIT / CAPITAL

5. INCREASED DEMAND IS PERMANENT6. INCREASE IN OUTPUT IMMEDIATELY LEADS TO

INCREASE IN INVESTMENT

MULTIPLIER ACCELERATION INTERACTION


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TIME

t

INITIALINVESTMENT

INDUCEDCONSUMPTION

[c= 0.5]

INDUCEDINVESTMENT

[v = 2]

INCREASE ININCOME

[COL. 2+3+4]

t+1 100 - - 100

t+2 100 50 100 250

t+3 100 125 150 375

t+4 100 187.50 125 412.50

t+5 100 206.25 37.50 343.75

t+6 100 171.88 - 68.74 203.14

t+7 100 101.57 - 140.62 60.95

t+8 100 30.48 - 142.18 -- 11.70

t+9 100 - 5.48 - 72.66 -21.49

t+10 100 10.75 - 33.20 43.95

MULTIPLIER - ACCELERATION INTERACTION


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INFLATION

TYPES OF INFLATION

1. DEMAND PULL INFLATION

WHEN DEMAND FOR GOODS & SERVICES CONTINUE TO INCREASEAND EXCEED THE SUPPLY OF GOODS AND SERVICES, THE PRICELEVEL WILL GO UP. BEYOND FULL EMPLOYMENT, INCREASE INDEMAND WILL BE FOLLOWED ONLY BY INCREASE IN PRICE ANDTILL FULL EMPLOYMENT, INCREASE IN DEMAND IS FOLLOWED BYINCREASE IN OUTPUT AND PRICE.

2. COST PUSH INFLATION

WITH INCREASE IN PRICE, THE DEMAND FOR MORE WAGES ANDSALARIES GOES UP. WHEN THIS IS MET, THE COST OFPRODUCTION WILL INCREASE. TO OFF-SET THIS, THEMANUFACTURERS INCREASE THE PRICE [i.e., pass on the increase incost of production to the ultimate consumers]


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PHILIPS CURVE [UNEMPLOYMENT AND INFLATION]

1 2 3 4 5

6

5

4

3

2

1

3

2

1

0

- 1

- 2

PRICE WAGE

UNEMPLOYMENT RATE

CONTROL OF BUSINESS CYCLES FISCAL POLICY


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CONTROL OF BUSINESS CYCLES FISCAL POLICY

INSTRUMENTS OF FISCAL POLICY- TAX

- PUBLIC EXPENDITURE- PUBLIC DEBT

TAX - PRINCIPLES OF TAXATION A] BENEFIT PRINCIPLE

- B] ABILITY TO PAY PRINCIPLE- TYPE OF TAX - a] Progressive b] Proportional c] Regressive

- DIRECT TAX & INDIRECT TAX JUSTIFICATIONS- EFFECTS OF TAXES- TAX AS A FISCAL INSTRUMENT OF CONTROL


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INSTRUMENTS OF FISCAL POLICY [CONTD..]

PUBLIC EXPENDITURE

JUSTIFICATIONS EFFECTS OF PUBLIC EXPENDITURE CONTROL OF PUBLIC EXPENDITURE AS AN INSTRUMENT OF FISCAL CONTROL

PUBLIC DEBTJUSTIFICATIONS

. EFFECTS OF PUBLIC DEBTS

. DEBT SERVICING

. DEBT REDEMPTION


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CONTROL OF BUSINESS CYCLES - MONETARY POLICY

MEANING OF MONETARY POLICY

INSTRUMENTS OF MONETARY POLICYCREDIT CONTROL POLICYA] QUANTITATIVE CREDIT CONTROLS

- BANK RATE POLICY

- OPEN MARKET OPERATIONS- VARIABLE RESERVE RATIO

B] QUALITATIVE CREDIT CONTROLS- CONSUMER CREDIT REGUALTIONS

- MARGIN REQUIREMENTS- MORAL SUASION- DIRECT ACTION

BALANCE OF PAYMENT


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Current account1. MERCHANDISE

Exports of goods on FOB - credit items

Imports of goods on CIF - debit items2. INVISIBLESCreditsReceipts of :

Value of services rendered by residents to non-residentsIncome earned by residents on ownership of financial assetsUse of non-financial assets [property income]Cash or kind without transfer payments

DebitsRemittances under the above items Made by residents tonon - residents


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CAPITAL ACCOUNT Debits Credits

Countrys foreign Financial Assets Increase Decrease Foreign financial liabilities Decrease Increase MONETARY MOVEMENTS Repayments made to IMF or Addition made to existing reserves Debit Drawings from the IMF or drawing down Of reserves Credit

METHODS OF CORRECTING BALANCE OF PAYMENTS


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DISEQUILIBRIUM

MEANING : ANY ADVERSE BALANCE OF PAYMENTS IS CALLEDDISEQUILIBRIUM

TYPE OF DISEQUILIBRIUM

STRUCTURAL DISEQUILIBRIUM FUNDAMENTAL DISEQUILIBRIUM

METHODS OF CORRECTING DISEQUILIBRIUM

EXCHANGE DEPRECIATION DEVALUATION EXCHANGE CLEARING AGREEMENTS EXCHANGE CONTROLS

TARIFFS QUOTAS

MONEY STOCK MEASUREMENTS


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A. MONETARY AGGREGATESCONSTITUTENTS

M0 = Currency in circulation + Bankers deposits with RBI + Other deposits with RBI[Weekly]

M1 = Currency with public + Demand deposits with banks + Other deposits with RBI[Fortnightly]

M2 = M1 + Time liabilities portion of savings deposits with banks +

Certificates of deposit issued by banks + term deposits [maturity upto 1 year][Fortnightly]

M3 = M2 +Term deposits with maturity above 1 year with banks + callborrowings from Non depository financial corporations by the banks


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HIGH POWERED MONEY


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HIGH POWERED MONEY

High powered money = Monetary liabilities of RBI + Govt.money

[i.e., currency issued by RBI + reserves held bythe commercial banks with RBI + other depositswith RBI ]RBI Assets = RBI LIABILITIESFA + OA = ML + NMLMs [with the influence of time deposits with commercial banks]

= [ 1 + c + t ] / c + r [1 +t]Ms [ without the influence of time deposits with commercial

banks]= [1 + c] / [ c + r]

With excess reserve m = [1 + c] / [r + c + e]

MONETARY LIABILITIES


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1. NOTES IN CIRCULATION

2. OTHER DEPOSITSA. Deposits of quasi-government

b. Balances in the accounts of foreign central banks and governmentsc. Accounts of internal agencies such as theIMF, etc.

3. Deposits of Banks [Reserves]

NON MONETARY LIABILITIES


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NON MONETARY LIABILITIES

B. Capital account

C. Government depositsD. IMF AccountsE. Miscellaneous - Bills payable, Pension fund,

etc.


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OPEN ECONOMY


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OPEN ECONOMY

STERILIZATION- Contractionary & Expansionary monetary policy to correct imbalance due to foreignexchange reserve is called sterilization

POLICY MIX FOR BALANCE


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1. INTERNAL BALANCE : Full employment &[S I] Price stability

2. EXTERNAL BALANCE : Current account[X M ] balance [surplus / deficit]

To achieve both internal and external balance

Policy mix :Reduce govt. spending [fall in S I] andDevaluation [rise in X M]

POLICY MIX FOR EXTERNAL & INTERNALBALANCE


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BALANCE

S I *

S I

X - M

X M*

EX.BAL

INT.BAL

FE


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LAGS IN MONETARY POLICY


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t 1 Equilibrium status

t 2 - When C + I fluctuate there is need for correction

t 3 - Policy action is initiated

t 4 - Time taken for policy to become effective



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INSIDE LAG OUTSIDE LAGI NTERMEDI ATELA GRECOGNITION

LAG

ADMINISTRATION

LAG

DECISION

LAG

PRODUCTION

LAG

ACTIONNEEDED

NEEDRECOGNISED

ACTION

TAKEN

EFFECT

FELT ON RI &CREDITCONDITIONS

EFFECTFELT ONSPENDING

DECISIONS

EFFECTFELT ONOUTPUT

& N

FISCAL POLICY


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BUDGET DEFICIT AND THE GOVERNMENT DEBTDefinitions

Revenue receipts = Tax revenue + Non - tax revenue[Direct taxes + Indirect taxes + internal

receipts + Total profit ]Capital receipts = Recoveries of Loans + Other

capital receipts + Borrowingsand other liabilities

Revenue expenditure = Non plan expenditure on revenue

a/c + Plan expenditure onrevenue a/cCapital expenditure = Non plan expenditure on capital

a/c + Plan expenditure on

capital a/c

FISCAL POLICY


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Revenue deficit = Revenue expenditure - Revenue receipts

Fiscal deficit = Total expenditure ( Revenue receipts + Recoveries of

loans + Other capital receipts )

Primary deficit = Fiscal deficit - Interest payments

Non plan expenditure = Interest payments + Subsidies + Defenseexpenditure

FISCAL POLICY


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Example : 1The following estimates are extracted from the Budget for 19xx 19xx

Rs. In CroresTax revenue 1,16,857Non tax revenue 45,137Recoveries of loans 9,908Other capital receipts 5,000Borrowing and other liabilities 91,025Non plan expenditure

On revenue account 1,66,301[of which interest payment is 75,000]On Capital account 29,624

Plan expenditure

On Revenue account 43,761On capital account 28,241

Calculate : Revenue receipts, Capital receipts, Revenue expenditure, Capitalexpenditure, Revenue deficit, Fiscal deficit and Primary deficit

FISCAL POLICY


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Solution :

Revenue receipts = 1,16,857 + 45,137 =

1,61,994Capital receipts = 9,908 + 5,000 + 91,025 =

1,05,933

Revenue expenditure = 1,66,301 + 43,761 =

2,10,062Capital expenditure = 29,624 + 28,241 = 57,865

Revenue deficit = 2,10,062 - 1,161,994 =48,068

Fiscal deficit = 2,67,927 - [1,61,994 + 9,908 + 5,000]91,025

Primary deficit = 91,025 - 75,000 = 16,025

Macro Economics All 1

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