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Macro Economics

This book is a part of the course by uts, Pune.This book contains the course content for Macro Economics.

JNU, JaipurFirst Edition 2013

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Index

I. Content .................................................................... II

II. List of Figures ........................................................ V

III. List of Tables .......................................................VI

IV. Abbreviations ..................................................... VII

V. Case Study ............................................................. 74

VI. Bibliography ........................................................ 78

VII. Self Assessment Answers .................................. 81

Book at a Glance

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Contents

Chapter I ....................................................................................................................................................... 1Introduction to Macroeconomics ................................................................................................................ 1Aim ................................................................................................................................................................ 1Objectives ...................................................................................................................................................... 1Learning outcome .......................................................................................................................................... 11.1 Introduction .............................................................................................................................................. 21.2 Macroeconomics ...................................................................................................................................... 2 1.2.1 History of Macroeconomics ..................................................................................................... 2 1.2.2 Economic Growth .................................................................................................................... 3 1.2.3 Relationship between inflation and growth ............................................................................. 41.3 Goals and Instruments of Macroeconomics ............................................................................................. 41.4 Instruments of Macroeconomics .............................................................................................................. 7Summary ....................................................................................................................................................... 8References ..................................................................................................................................................... 8Recommended Reading ............................................................................................................................... 8Self Assessment ............................................................................................................................................. 9

Chapter II ....................................................................................................................................................11Aggregate Demand Supply and Measurement of Output .......................................................................11Aim ...............................................................................................................................................................11Objectives .....................................................................................................................................................11Learning outcome .........................................................................................................................................112.1 Definition of Aggregate Demand and Supply ........................................................................................ 12 2.1.1 Aggregate Demand and Supply Curve ................................................................................... 132.2 GDP (Gross Domestic Product) ............................................................................................................. 13 2.2.1 Entities of GDP ...................................................................................................................... 152.3 GDP at Factor Cost and GDP at Market price ....................................................................................... 152.4 Gross National Product (GNP) .............................................................................................................. 162.5 Net Domestic Product and Net National Product .................................................................................. 162.6 Real and Nominal GDP .......................................................................................................................... 162.7 Per Capita Income and Personal Disposable Income ............................................................................ 16Summary ..................................................................................................................................................... 17References ................................................................................................................................................... 17Recommended Reading ............................................................................................................................. 17Self Assessment ........................................................................................................................................... 18

Chapter III .................................................................................................................................................. 20Consumption Investment and Supply of Money ..................................................................................... 20Aim .............................................................................................................................................................. 20Objectives .................................................................................................................................................... 20Learning outcome ........................................................................................................................................ 203.1 Meaning and Definition of Consumption .............................................................................................. 21 3.1.1 Marginal Propensity to Consume (MPC) .............................................................................. 223.2 Investment .............................................................................................................................................. 243.3 Money Supply ........................................................................................................................................ 25 3.3.1 Exogenous and Endogenous Process of Money Supply ........................................................ 25 3.3.2 High Powered Money and Money Supply ............................................................................. 25 3.3.3 Measures of Money Supply in India ...................................................................................... 26Summary ..................................................................................................................................................... 27References ................................................................................................................................................... 27Recommended Reading ............................................................................................................................. 27Self Assessment ........................................................................................................................................... 28

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Chapter IV .................................................................................................................................................. 30Business Cycle and Inflation ..................................................................................................................... 30Aim .............................................................................................................................................................. 30Objectives .................................................................................................................................................... 30Learning outcome ........................................................................................................................................ 304.1 Meaning and Definition of Business Cycle ........................................................................................... 31 4.1.1 Real Example of the Phases of Business Cycle ..................................................................... 31 4.1.2 Characteristics of Recession in Business Cycle .................................................................... 324.2 Inflation .................................................................................................................................................. 32 4.2.1 Causes of Inflation ................................................................................................................. 32 4.2.2 Measurement of Inflation ....................................................................................................... 34Summary ..................................................................................................................................................... 35References ................................................................................................................................................... 35Recommended Reading ............................................................................................................................. 35Self Assessment ........................................................................................................................................... 36

Chapter V ................................................................................................................................................... 38Monetary Policy ......................................................................................................................................... 38Aim .............................................................................................................................................................. 38Objectives .................................................................................................................................................... 38Learning outcome ........................................................................................................................................ 385.1 Meaning and Definition of Monetary Policy ......................................................................................... 395.2 How to Achieve the Goals of Monetary Policy? ................................................................................... 395.3 Monetary Measures ................................................................................................................................ 40Summary ..................................................................................................................................................... 42References ................................................................................................................................................... 42Recommended Reading ............................................................................................................................. 42Self Assessment ........................................................................................................................................... 43

Chapter VI ................................................................................................................................................. 45Fiscal Policy ................................................................................................................................................ 45Aim .............................................................................................................................................................. 45Objectives .................................................................................................................................................... 45Learning outcome ........................................................................................................................................ 456.1 Meaning and Definition of Fiscal Policy ............................................................................................... 466.2 Techniques of Fiscal Policy ................................................................................................................... 466.3 Fiscal Policy during Economic Boom ................................................................................................... 476.4 Balanced Budget .................................................................................................................................... 47Summary ..................................................................................................................................................... 49References ................................................................................................................................................... 49Recommended Reading ............................................................................................................................. 49Self Assessment ........................................................................................................................................... 50

Chapter VII ................................................................................................................................................ 52Macroeconomic Models ............................................................................................................................. 52Aim .............................................................................................................................................................. 52Objectives .................................................................................................................................................... 52Learning outcome ........................................................................................................................................ 527.1 Introduction ............................................................................................................................................ 537.2 Common assumptions ............................................................................................................................ 53 7.2.1 Unemployment and hours worked are directly related .......................................................... 53 7.2.2 The central bank has complete control over money supply. ................................................. 53 7.2.3 Monetary policy = change in money supply .......................................................................... 53 7.2.4 There is just one interest rate. ............................................................................................... 53 7.2.5 Exchange rate ......................................................................................................................... 53

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7.2.6 Capital Flows ......................................................................................................................... 547.3 Classical Models - The Role of Aggregate Supply ................................................................................ 54 7.3.1 A Simple Classical Model ...................................................................................................... 54 7.3.2 The Classical Model .............................................................................................................. 567.4 Keynesian Models - The Role of Aggregate Demand ........................................................................... 57 7.4.1 The Simple Keynesian Model ................................................................................................ 57 7.4.2 The IS/LM Model .................................................................................................................. 57 7.4.3 The IS/MP Model ................................................................................................................... 58Summary ..................................................................................................................................................... 60References ................................................................................................................................................... 60Recommended Reading ............................................................................................................................. 60Self Assessment ........................................................................................................................................... 61

Chapter VIII ............................................................................................................................................... 63Open Economy Macroeconomics ............................................................................................................. 63Aim .............................................................................................................................................................. 63Objectives .................................................................................................................................................... 63Learning outcome ........................................................................................................................................ 638.1 Introduction ............................................................................................................................................ 648.2 The Complete Short run Open economy Macroeconomic model.......................................................... 64 8.2.1 The aggregate goods market – The simple Keynesian Model. .............................................. 64 8.2.2 The Aggregate Money Market .............................................................................................. 65 8.2.3 The Foreign Exchange Market, Which is linked To the Balance of Payments Account ....... 668.3 Kaleckian macro models for open economies ....................................................................................... 70Summary ..................................................................................................................................................... 71References ................................................................................................................................................... 71Recommended Reading ............................................................................................................................. 71Self Assessment ........................................................................................................................................... 72

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List of Figures

Fig. 1.1 GDP growth rate of India from Jan-2006 to June-2010 ................................................................... 5Fig. 1.2 Percentage of population in age group of 15-59 years ..................................................................... 6Fig. 1.3 Employment (in millions) during 1993-94 to 2004-05 .................................................................... 6Fig. 2.1 Aggregate demand and supply determine the macroeconomic variables ....................................... 12Fig. 2.2 Aggregate demand and supply curve .............................................................................................. 13Fig. 2.3 Two parameters for the measurement of GDP ................................................................................ 14Fig. 3.1 Plot of consumption function ......................................................................................................... 22Fig. 3.2 The MPC curve ............................................................................................................................... 23Fig. 3.3 Marginal efficiency of capital ......................................................................................................... 24Fig. 4.1 Phases of business cycle ................................................................................................................. 31Fig. 4.2 Demand pull inflation ..................................................................................................................... 33Fig. 4.3 Cost push inflation curve ................................................................................................................ 34Fig. 5.1 Flowchart for the process of monetary policy ................................................................................ 40Fig. 6.1 Fiscal policy in economic boom ..................................................................................................... 47Fig. 7.1 The simple classical model ............................................................................................................. 55Fig. 7.2 The classical model......................................................................................................................... 56Fig. 7.3 The IS/LM diagram ........................................................................................................................ 58Fig. 7.4 The IS/MP diagram ......................................................................................................................... 59Fig. 8.1 Aggregate goods market ................................................................................................................. 64Fig. 8.2 IS Curve .......................................................................................................................................... 65Fig. 8.3 Aggregate money market ................................................................................................................ 65Fig. 8.4 LM Curve ....................................................................................................................................... 66Fig. 8.5 Overall b alance .............................................................................................................................. 67Fig. 8.6 Types of exchange rate regime ....................................................................................................... 68Fig. 8.7 Fixed exchange rate ........................................................................................................................ 69

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List of Tables

Table 1.1 Goals and instruments of macroeconomics.................................................................................... 4Table 1.2 GDP Growth rate of India for the year 2010 .................................................................................. 5Table 3.1 Categories of consumptions ......................................................................................................... 21Table 3.2 Consumption data ........................................................................................................................ 21Table 3.3 Marginal propensity to consume .................................................................................................. 23Table 4.1 Turning point dates of current economy ...................................................................................... 32

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Abbreviations

CPI - Consumer Price IndexCRR - Cash Reserve RatioGDP - Gross Domestic ProductGNP - Gross National ProductMPC - Marginal Propensity to ConsumeNDP - Net Domestic ProductNFIA - Net Factor Income from AbroadNNP - Net National ProductNSSO - National Sample Survey OrganizationPPI - Producer Price Index RBI - Reserve Bank of India RRR - Reverse Repo Rate WPI - Wholesale Price Index

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Chapter I

Introduction to Macroeconomics

Aim

The aim of this chapter is to:

define macroeconomics•

enlist the goals and instruments of macroeconomics•

explain central theme of macroeconomics•

Objectives

The objectives of this chapter are to:

describe business cycle and economic growth•

enlist the reasons behind inflation and economic growth•

explain fiscal policy and monetary policy•

Learning outcome

At the end of this chapter, you will be able to:

understand the concept of macroeconomics and its role•

identify the role of GDP in economic growth•

understand fiscal policy and monetary policy•

Macro Economics

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1.1 IntroductionEconomics is the study of how society manages its scarce resources. In most societies, resources are allocated not by single central planner but through the combined actions of millions of households and firms. Economists therefore study how people make decisions: how they work, what they buy, how much they save, and how they invest their savings. Economists also study how people interact with one another. For instance, they examine how the multitude of buyers and sellers of a good together determine the price at which the good is sold and the quantity that is sold. Finally, economists analyse forces and trends that affect the economy as a whole, including the growth in average income, the fraction of the population that cannot find work, and the rate at which prices are rising.

Thus, economics studies:Society• Utilisation of scarce resources• Satisfying unlimited wants• Description of various scopes at individual and national level.•

1.2 MacroeconomicsMacroeconomics is the study of the entire economy in terms of the total amount of goods and services produced, total income earned, the level of employment of productive resources, and the general behavior of prices. Macroeconomics can be used to analyze how best to influence policy goals such as economic growth, price stability, full employment and the attainment of a sustainable.

1.2.1 History of Macroeconomics

The modern macroeconomics first began in 1936, when John Maynard Keynes described the concept in his first • publication as, “The General Theory of Employment, Interest and Money.”The General Theory was written during the Great Depression. According to the book, the level of employment • is determined not by the price of labour, but by spending of money. He also argues that it is wrong to assume that competitive market will, in the long run, deliver full employment and equilibrium state of a monetary economyMacroeconomics deals with the aggregates of the system. The word macro means large. Macroeconomics, thus, • deals with the behaviour of various economic variables that refer to the economy as a whole. These variables are— total national income, aggregate employment, the extent to which the economy’s resources are being fully employed, aggregate saving and investment, and the general price level in the economy.

The central idea of macroeconomics is based on the following issues:Why do employment and output sometimes fall, and how to reduce unemployment?

The expansion and contraction of market is based on business cycles. The last major downturn in the United • States occurred in 1999-2001 during the terror attack on the World Trade Centre (WTC).The key concept behind economic recovery is the reduction in unemployment rate. As per the economist Frank • Shostak, the unemployment rate was almost 15 million in August 2009.Reduction in unemployment is the real activity of an economy. The main driver of economic growth is the escalation • of the pool of real savings. Here real saving means the enhancement and expansion of infrastructure.A developed infrastructure permits the production of final goods and services required to maintain the economic • platform and growth of individual and nation.Globalization and rapid technological development gives rise to increased labour mobility and brings new • employment opportunities, which, in turn, needs enhanced human resource development.Currently, in many developed countries, growth in employment is great in small and medium-sized enterprises • and in self-employment. In many developing countries, informal sector activities are often the leading source of employment opportunities for people with limited access to formal-sector wage employment, particularly for women.

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The removal of obstacles to the operation of such enterprises and the provision of support for their creation • and expansion must be accompanied by protection of the basic rights, health and safety of workers and the progressive improvement of overall working conditions, together with the strengthening of efforts to make some enterprises part of the formal sector.

Two major themes can be figured out through the survey of macroeconomics:Business cycle: • fluctuation in output, employment and prices is called as Business Cycle.Economic growth: • this includes living standards and long term trends like national income, economic problems and economic fluctuation and so on.

1.2.2 Economic GrowthAn increase in the capacity of an economy to produce goods and services, compared from one period of time to another. Economic growth can be measured in nominal terms, which include inflation, or in real terms, which are adjusted for inflation. For comparing one country’s economic growth to another, GDP or GNP per capita should be used as these take into account population differences between countries.

Economic growth is usually associated with technological changes. An example is the large growth in the U.S. economy during the introduction of the Internet and the technology that it brought to U.S. industry as a whole. The growth of an economy is thought of not only as an increase in productive capacity but also as an improvement in the quality of life to the people of that economy.

How can a nation increase its rate of economic growth?Macroeconomics is concerned with economic growth in terms of production potential of an economy.• The improvement of • quantity and quality of factors of production like land, labour and capital increases the economic growth rate.

Improving the quantity and quality of following scarce resources can lead to high economic growth:Land

Increase in land available for agricultural propose will increase the economic growth. Bush land is highly used • for the agricultural purpose, so it is no longer a habitat for wildlife.Due to the diminished marginal return, if more labourers are used for converting bush land to agricultural land • then the productivity of labour will decrease. To prevent this loss in productivity, the quality of land must be improved. This can be done with better application of technology and improved irrigation facility.

Human resourceAs per the basic concept, we know that,Increase in population > Increase in the number of young people entering into the labour force> Increase the supply of labour > Increase in economic growth.

We can say that the mere increase in quantity of labour does not lead to the economic growth but, quality also plays a crucial role. Here quality refers to skill set of labourers. For example, in India, the IT companies train their employees for better output. This results in the economic growth in India.

CapitalCapital resources are of two types,

Directly productive capital (plant and equipments)• Indirectly productive capital (infrastructures like road and railways)•

The process of acquiring capital is called as investment. The level of investment and the quality of investment directly affects the economic growth of a nation.

Macro Economics

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1.2.3RelationshipbetweeninflationandgrowthInflation is referred to the general rise in prices considering the purchasing power of common man. The relationship between inflation and growth remains a controversial one in both theory and empirical findings. Originating in the Latin American context in the 1950s, the issue has generated an enduring debate between structuralists and monetarists. The structuralists believe that inflation is essential for economic growth, whereas the monetarists see inflation as detrimental to economic progress.

There are two aspects to this debate: The nature of the relationship if one exists and • The direction of causality. Friedman (1973: 41) succinctly summarized the inconclusive nature of the relationship • between inflation and economic growth as follows: ―historically, all possible combinations have occurred: inflation with and without development, no inflation with and without development. The impact of inflation on growth, output and productivity has been one of the main issues examined in macroeconomics.

Whatarethefactorsresponsibleforinflation,andhowcanitbekeptundercontrol?As per the survey report of 2009-10, in India, the food inflation increased in double digit which affected all other sectors as well. For 2009, Indian inflation stood at 11.49%. Such rate increases the prices of commodity and also affects the purchasing power of common man. As per the survey, the economy is expected to grow at a rate of 9% in the year 2011-12.

Macroeconomics suggests the proper role of monetary and fiscal policies of exchange rate system, and an independent central bank in containing inflation.

There are two main causes of inflation:Rise in demand or Demand Pull Inflation• Rise in cost of factor production or Cost Push Inflation.•

1.3 Goals and Instruments of MacroeconomicsThe main objectives are goals of the government policies, whereas the tools and strategies to achieve these goals are called as instruments. The major instruments are mentioned in the table below:

Goals Instruments

Output: Growth in output Monetary Policy: changes in interest rate, supply in money and credit

Employment: High level of employment Fiscal Policy: changes in government taxation, policies and expenditure

Table 1.1 Goals and instruments of macroeconomics

OutputThe main objective of economic activity is to provide the essential goods and services to people. These goods • and services are nothing but the output of a nation. The most comprehensive measure of the total output is Gross Domestic Product (GDP). GDP is the total market value of all product and services produced by a nation or a country in a given year.The Gross Domestic Product (GDP) in India expanded at an annual rate of 8.80% in the last reported quarter. • From 2004 to 2010, India’s average quarterly GDP growth was 8.37%, reaching an historical high of 10.10% in September, 2006 and a record low of 5.50 percent in December, 2004, as shown in Fig. 1.1 and Table 1.2.India’s diverse economy encompasses traditional village farming, modern agriculture, handicrafts, a wide range • of modern industries, and a multitude of services.

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Services are the major source of economic growth, accounting for more than half of India’s output with less • than one third of its labour force.

11

10

9

8

7

6

5

11

10

9

8

7

6

5Jan/2006 Jan/2007 Jan/2008 Jan/2009 Jan/2010

INDIA GDP GROWTH RATE

Annual GDP Growth Adjusted by inflation

50%

of

date

po

ints

100%

of

date

poi

nts

Max;10.1

Mean;8.42

Min;5.8

8.80% as per second quarter of the year 2010

Fig. 1.1 GDP growth rate of India from Jan-2006 to June-2010(Source: TradingEconomics.com: India’s Central Statistical Organisation)

Year Mar Jun Sep Dec

2010 8.60 8.80

2009 5.80 6.00 8.60 6.50

2008 8.50 7.80 7.50 6.10

Table 1.2 GDP Growth rate of India for the year 2010

High EmploymentPeople want high-paying job within short time period, with assured job security and good benefits. In • macroeconomics terms, these are the main goals of high employment.Currently, India is passing through the ongoing demographic changes which cause increase in the size of labour • force in the country. As per Govt. of India, Ministry of Labour & Employment, the working age group (15-59 years) is likely to increase from 58% in 2001 to 64% by 2021.

Macro Economics

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66

64

62

60

58

56

54

% p

opul

atio

n in

15-

59 y

ears

age

gro

up

Percentage of Population in Age group of 15 - 59 Years

Year

57.7

60.4

62.763.9 64.2

2001 2008 2011 2016 2021

Fig. 1.2 Percentage of population in age group of 15-59 years

As per the survey conducted by NSSO (National Sample Survey Organisation), employment figure in the Indian market for the year 2004-05 was 385 million. The data for year 2009-10 is still in progress by NSSO. The employment during year 1993-94 to 2004-05 is as shown below:

500

450

400

350

300

250

200

150

100

50

0

Tota

l em

ploy

men

t (in

mill

ions

)

1983 1993-94 1999-2000 2004-2005

Years

239

314338

385

Fig. 1.3 Employment (in millions) during 1993-94 to 2004-05(Source: MoL&E, 2008 and Planning Commission, 2008)

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1.4 Instruments of MacroeconomicsFollowing are different instruments of macroeconomicsFiscal policyFiscal policy is made by the government for controlling the government expenditure, supply of money and taxes. Government expenditure has two distinct forms:

Government spending on various goods and services like purchasing of tanks, construction of roads and railways, • salaries for judges and so on.Government transfers the payments to the targeted group such as elderly or unemployed people to boost them • up.

TaxationTaxation is another part of fiscal policy that affects the overall economy in two ways:

Tax affects the prices of goods and factors of production, thereby affecting the incentive and behaviour.• Tax tends to affect the amount that people spend on goods and services as well as amount of private saving.•

Private consumption and savings have important effects on investment and output in short run and long run.

Monetary PolicyMonetary policy is one of the tools that a national government uses to manage its economy. Using its monetary authority to control the supply and availability of money, a government attempts to manage the overall level of economic activity.

Monetary policy is usually administered by the government appointed “Central Bank” and the “Federal Reserve • Bank” in the United States.The money supply has a large impact on macroeconomic activities. By changing money supply, the Federal • Reserve Bank can influence many financial and economic variables such as interest rates, stock price, exchange rates, etc. If the money supply is restricted, then the interest rate will be high and it will cause decline in GDP and investment as well.

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SummaryThe first part of the chapter covered the general introduction of macroeconomics and described the two major • themes of macroeconomics called the Business Cycle and Economic Growth.Fluctuation on output, employment and prices is called Business Cycle. • Living standards and long term trends like national income, economic problems and fluctuations, etc., come • under economic growth.Next part described the central idea of macroeconomics, which include low unemployment, high GDP and low • inflation rate. Some of the major goals of macroeconomics are output and employment. • Similarly, the instruments which are used in macroeconomics are Fiscal policy and Monetary Policy.• Fiscal policy is made by government for controlling the government expenditure, supply of money and taxes. • Monetary policy is used by government to manage its economy. Using its monetary authority, a nation controls • the supply and availability of money and attempts to manage the overall level of economic activity.

ReferencesShostak, F., 2010. • Unemployment is the key to US Economy. [Online] Available at: <http://mises.org/daily/4724> [Accessed 10 November 2010].Introduction to Macroeconomics• , [Online] Available at: <http://www.scribd.com/doc/12374776/Overview-of- Macroeconomics> [Accessed 10 November 2010].Dornbusch, R., 2005. • Macroeconomics. Tata McGraw-Hill EducationHubbard, R. G., 2007. • Macroeconomics. Pearson Education India.Petrov, K., • Macroeconomics, Lecture 01, [Video Online] Available at: <http://www.youtube.com/watch?v=INPhEyH_gH0> [Accessed 17 August 2012]Economics 1 - Lecture 16: Overview of Macroeconomics• , [Video Online] Available at: <http://www.youtube.com/watch?v=DJwuQ6VLi1U> [Accessed 17 August 2012]

Recommended ReadingDr. Mithani, D. M., 2008. • Managerial Economics (Theory and Application), Himalaya Publishing House Pvt. Ltd.Paul, A. S., 2002. • Economics, Massachusetts Institute of Technology, Tata McGraw-Hill Publishing Company.Gupta, S. B., 2009. • Monetary Economics, Money and Payment System, S. Chand & Company, New Delhi.

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Self AssessmentWhich of the following is not included in the study of economics?1.

Societya. Utilisation of scarce resources b. Satisfying unlimited wantsc. Origin of taxationd.

Which of the following statement is true?2. Macroeconomics is concerned with economic growth in terms of production potential of an economy. a. Macro economy activities involve low capital.b. Macro economy activities involve low labour.c. Macro economy activities involve low economic growthd.

As per the “General Theory” written by John Maynard Keynes,3. Employment is determined not by the price of labour but by spending of money. a. Employment is determined the price of labour.b. Employment is determined by spending of money.c. Employment is determined not by the price and by spending of money.d.

What is the meaning of real saving?4. Saving by individual a. Saving of companyb. Enhancement and expansion of infrastructurec. Saving of Governmentd.

What is the meaning of inflation?5. Inflation is referred to the general rise in production capacity.a. Inflation is referred to the general rise in prices considering the purchasing power of common man.b. Inflation is referred to the general fall in prices.c. Inflation is referred to the general fall in cost of production.d.

How many types of capital resources are there?6. One a. Twob. Threec. Fourd.

____________ policy is one of the tools that a national government uses to manage its economy.7. Fiscala. Governmentb. Taxationc. Monetaryd.

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The most comprehensive measure of the total output is _________.8. GDPa. GNPb. per capita incomec. law of diminishing marginal returnd.

People want high-paying job within short period of time. In macroeconomics terms, this concept is called 9. ___________.

Low employment a. High employment b. High profile jobc. Private jobd.

In U.S.; monetary policy is usually administered by the ___________.10. co-operative societiesa. government appointed ‘Central Banks’b. international banksc. private banksd.

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Chapter II

Aggregate Demand Supply and Measurement of Output

Aim


define aggregate demand and aggregate supply of macroeconomics•

formulate various measurements of macroeconomics•

elucidate per capita income and personal disposable income•

Objectives


explain the meaning of aggregate demand and supply•

enlist the entities of GDP and give brief elaboration of each•

formulate the equation of per capita income and personal disposable income•

Learning outcome


understand the reasons behind fluctuation of aggregate demand and supply•

understand rotation of money and how it will help in economy•

identify the entities and equation of GDP in market price and in cost factor•

Macro Economics

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2.1DefinitionofAggregateDemandandSupplyTo explain the major trends of output and prices, economists developed the concept of aggregate demand supply • analysis. This Aggregate demand and supply is one of the important tools in macroeconomics which helps in measuring various events of economics. Basically, firms get demand from four main sources like:

Households (personal consumption) �Firms (investment) �Government agencies (government purchases) �Foreign market (net export). �

Aggregate demand is the relationship between total quantity of goods and services demanded from all four • sources and the price level of respective goods and services.Aggregate supply refers to the total quantity of goods and services that a particular nation is willing to produce • and sell in given period.Aggregate supply depends upon the price level and cost of production, output generated and the optimum • utilization of scarce resources (land, labour and capital).The potential output or the output generated by any firm or nation is determined by the availability of productive • input like labour and capital.Using both, the combination of demand and supply, we achieve the resulting output which determines the • employment, prices and GDP of a nation.

AggregateDemand

Output(real GDP)

Monetary policy-Investment

& Government Agencies

Fiscal Policy

other forcesPersonal

consuption, Foreign market

Price level and costs

Potentialoutput

Capitallabor,Technology

Employment and

Unemployment

Prices and

inflation

Foreigntrade

AggregateSupply

Interaction of aggregate supply

and demand

Fig. 2.1 Aggregate demand and supply determine the macroeconomic variables(Source: Samuelson, P A. & Nordhaus, W. D., Economics)

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2.1.1 Aggregate Demand and Supply CurveFigure below shows the aggregate supply and demand schedule for the output of an entire economy. On the horizontal, or quantity, axis is the total output (Real GDP) of the economy. On the vertical axis is the overall price level (measure by consumer price index). We use the symbol Q for Real GDP and P for Price level.

The downward slope of curve is the Aggregate Demand Schedule named AD. It represents what everyone – • consumers, businesses, foreigners and government would buy at different aggregate price level.From the curve, we can see that, when the price level is at 150, total spending will be $3000 billion per year. If • the price level rises to 200, total spending will fall to $2300 billion.The upward sloping curve is the Aggregate Supply Schedule, or AS curve. This curve represents the quantity • of goods and services that businesses are willing to produce and sell at each price level.According to the curve, business will want to sell $3000 billion at a price level of 150. They will want to sell • a higher quantity, $3300 billion, if prices rise to 200. As the level of total output demanded rises, business will want to sell more goods and services at a higher price level.The Macroeconomic Equilibrium curve is the point where the combination of overall price and quantity at which • all the buyers and sellers are satisfied with their purchase, sell and prices.If the price level is more than equilibrium, that means if P = 200, then business will try to sell more than what • the purchasers are willing to buy.Once the equilibrium is reached, neither buyer nor the suppliers will change their quantity of demand or • supply.

250

200

150

100

50

0

Pric

e in

dex

for

all c

omm

oditi

es

0 1,000 2,000 3,000 4,000 5,000Real GDP (billions)

BC

E

AD

ASP

Q

Fig. 2.2 Aggregate demand and supply curve(Source: Samuelson, P A. & Nordhaus, W. D., Economics)

2.2 GDP (Gross Domestic Product)GDP is the most comprehensive measure of nation’s total output of goods and services.

It is the sum total of Personal Consumption (C), Investment (I), Government Purchases (G) and Net Export • (Xn). Thus the equation is:

GDP = Consumption (C) + Investment (I) + Government Purchases (G) + Net Export (Xn) Or

GDP = C + I + G + XnGDP is used to measure the overall performance of an economy. For example, during the great depression of • 1929, which lasted 10 years, the GDP fell from $103 to $55 billion. There was a sharp decline in dollars value of goods and services and unemployment in US was 25% and wages fell 42%.

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GDP can be measured in two parameters :• Flow of Product �Earning or Cost �

Personal consumption

Consumer goodsand services

Firms Households

Factors of production(labor,capital,andnatural

resources)Factor incomes

(wages,interest,profit,andrent)

Fig. 2.3 Two parameters for the measurement of GDP(Source: Samuelson, P A. & Nordhaus, W. D., Economics)

Flow of productEvery year people consume wide variety of final goods and services like foods, software, cloths and so on. By • adding all the consumption rupees, we will arrive at the simplified economy’s total GDP.Sum of the annual flow of final goods and services (GDP) = (price of food X amount of food) + (price of • software X number of software) + (price of cloths X number of cloths)

Earning or costThe second equivalent way to calculate GDP is earning or cost approach. All costs like wages, rent, profits are • considered in this calculation.Annual flow of earnings and income also come under GDP.•

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2.2.1 Entities of GDPFollowing are the entities of GDPPersonal consumption

Personal consumption is a flow variable that measures the value of goods and services purchased by households • during a time period.Purchases of groceries, health-care services, clothing, automobiles and so forth all are counted as • consumption.

Private investmentsGross private domestic investment is the value of all goods produced during a period for use in the production • of other goods and services.Like personal consumption, gross private domestic investment is a flow variable. It is often simply referred to • as ‘private investment.’ A hammer produced for a carpenter is private investment. A printing press produced for a magazine publisher is private investment.

Government purchasesGovernment agencies at all levels purchase goods and services from firms. They purchase office equipment, • vehicles, buildings, janitorial services, and so on.Many government agencies also produce goods and services. For example, police departments produce police • protection: public schools produce education, and the National Aeronautics and Space Administration (NASA) produce space exploration.Government purchases are not the same thing as government spending. Much government spending takes the • form of transfer payments, which are payments that do not require the recipient to produce a good or service in order to receive them.Transfer payments include social security and other types of assistance to retired people, welfare payments to • poor people, and unemployment compensation to people who have lost their jobs.

Net exportSales of a country’s goods and services to buyers in the rest of the world during a particular time period represent • its exports.Whereas, imports are purchases of foreign-produced goods and services by a country’s residents during a • period.

Subtracting imports from exports yields net exports.

Net Export (Xn) = Export (X) – Imports (M)

2.3 GDP at Factor Cost and GDP at Market priceIn an economy, money flows in a circular manner, from producer to consumer and back from consumer toproducer. Hence, goods and services can be converted into monetary terms in two ways:

Market value of goods and services• Payments for factor inputs•

The calculation for GDP defined earlier is called as GDP at Market Price. This includes all indirect taxes and excludes subsidies.

On the contrary, GDP at Factor Cost excludes all indirect taxes and includes subsidies given by the government.GDP at Factor Cost = GDP at Market Price – Indirect Taxes + Subsidies

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2.4 Gross National Product (GNP)GNP is the combined value of all the final goods and services produced in a country during an accounting year, including net factor income from foreign countries.

GNP = GDP + NFIAWhere,NFIA = Net Factor Income from Abroad

2.5 Net Domestic Product and Net National ProductWhile calculating GDP and GNP, we ignore the depreciation of assets and capital consumption.• In order to arrive at NDP (Net Domestic Product) and NNP (Net National Product), we deduct the depreciation • from GDP and GNP.

NDP = GDP – DepreciationNNP = GNP – Depreciation

2.6 Real and Nominal GDPCalculating the GDP in a particular year using the actual market prices of that year gives us nominal GDP. But general interest is more towards real GDP, which is an index of quantity of goods and services produced. We get the real GDP by multiplying the quantity of goods to the set of its fixed price. When we divide nominal GDP by real GDP, we will get GDP deflator.

GDPDeflator=NominalGDP/RealGDP

2.7 Per Capita Income and Personal Disposable IncomeThe average income of the people of a country in a particular year is called per capita income. Per capita income • can be derived by dividing national income by total population.

PerCapitaIncome=NationalIncome/TotalPopulationSince it is calculated on the basis of national income, therefore it is referred to as per capita NNP, per capita • GNP or per capita GDP.Personal Disposable Income is received by the individuals of a country from all sources before direct taxes in • one year.

Personal Disposable Income = Personal Income – Personal Taxes

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SummaryAggregate demand is the relationship between total quantity of goods and services demanded.• Aggregate Supply refers to the total quantity of goods and services that a particular nation is willing to produce • and sell in given period.Aggregate supply also depends upon the price level and cost of production, output generated and the optimum • utilisation of scarce resources (land, labour and capital).In equilibrium point the buyer and the supplier both are satisfied with purchase and sell of goods and • services.Personal consumption is a flow variable that measures the value of goods and services purchased by households • during a time period. Gross private domestic investment is the value of all goods produced during a period for use in the production • of other goods and services. Government agencies at all levels purchase goods and services from firms. They purchase office equipment, • vehicles, buildings, janitorial services, and so on.Lastly, the chapter covered the various measurements of macroeconomics like GDP, GNP, NNP, NDP, Per Capita • Income and Personal Disposable Income and so on.

ReferencesKimberly, A., 2009. • Economic Depression, [Online] Available at: <useconomy.about.com/od/grossdomesticproduct/f/Depression.htm> [Accessed 12 November 2010].Aggregate Demand (AD) Curve,• [Online]. Available at: <http://www.cliffsnotes.com/study_guide/Aggregate-Demand-AD-Curve.topicArticleId-9789,articleId-9737.html> [Accessed 20 August 2012].Jhingan, M. L., 2010. • Meaning and Measurement of Macroeconomics, Managerial Economics. Delhi. Vrinda Publications Pvt. Ltd.Mankiw, N. G., 2008. • Brief Principles of Macroeconomics. Cengage Learning.Aggregate Supply and Aggregate Demand• , [Video Online] Available at: <http://www.youtube.com/watch?v=KX5XOxHAFpE> [Accessed 20 August 2012].Macro Unit 3 Intro- Aggregate Demand, Aggregate Supply, and Fiscal Policy• , [Video Online] Available at: <http://www.youtube.com/watch?v=6lnw7s9KOMM> [Accessed 20 August 2012].

Recommended ReadingDr. Mithani, D. M., 2008. • Business Cycle, Institute of Business Study and Research, Himalaya Publishing House Pvt. Ltd.Samuelson, P. A., 2002. • Economics, Measuring Economic Activity, Tata McGraw-Hill Publishing Company.Gupta, S. B., 2009. • Monetary Economic Money and Payment System, the Demand for Money, S. Chand & Company, New Delhi.

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Self AssessmentGDP is measured as________.1.

GDP = C + I + G + Xn a. GDP = C + I + G + Tb. GDP = C + I + T + Xnc. GDP = T + I + G + Xn (Where T= Tax)d.

_________ refers to the total quantity of goods and services that a particular nation is willing to produce and 2. sell in given period

Aggregate demand a. Aggregate supply b. Aggregate outputc. Aggregate inputd.

Which of the following also depends upon the price level and cost of production, output generated and the 3. optimum utilisation of scarce resources?

Aggregate demand a. Aggregate outputb. Aggregate inputc. Aggregate supplyd.

Which of the following is included in GDP at market price?4. Direct Taxa. Indirect Taxb. Subsidies by Governmentc. Per Capita Incomed.

Income received by the individuals of a country from all sources before direct taxes in one year is called as:5. Per Capita Incomea. Personal Disposable Income b. Gross National Incomec. National Incomed.

GNP is given by which of the equations?6. GNP=GDP-NFIAa. GNP= GDP- Depreciation b. GNP= GDP+NFIAc. GNP= NNP+ NDPd.

Per capita income can be derived by dividing national income by ___________7. total incomea. total populationb. GDPc. NNPd.

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Payments including social security and other types of assistance to retired people, welfare payments to poor 8. people, and unemployment compensation to people who have lost their jobs are called as ___________.

transfer payments a. no payments b. real paymentsc. nominal paymentsd.

Which of the following statements is true?9. While calculating GDP and NNP, we ignore the depreciation of assets and capital consumption aggregate a. supply While calculating GDP and GNP, we ignore the depreciation of assets and capital consumption supplyb. While calculating GDP and NDP, we ignore the depreciation of assets and capital consumptionc. While calculating GDP and GNP, we calculate the depreciation of assets and capital consumptiond.

National Aeronautics and Space Administration (NASA) producing space exploration is an example of 10. ___________.

private investmentsa. government purchases b. net exportc. NASA investmentd.

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Chapter III

Consumption Investment and Supply of Money

Aim


explain consumption, investment and basics of money supply in terms of high powered money supply•

explicate the concept of break-even point•

elucidate marginal propensity to consume with the help of graph•

Objectives


enlist the categories of consumption•

define the concept of investment and its various elements•

explain the concept of money supply•

Learning outcome


understand consumption and investment function•

identify the relationship between high powered money supply and money supply•

understand the components of high powered money supply•

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3.1MeaningandDefinitionofConsumptionIn the previous chapter, we discussed that consumption is one of the single largest component of GDP. Some of the most important categories of consumptions are mentioned in the table below.

Categories of Consumptions

Durable Goods Nondurable Goods Services

Motor vehicles and parts Food Housing

Furniture and household equipments Clothing Household operations

Others Energy goods Transportation

Others Medical care

Table 3.1 Categories of consumptions

One of the most important relationships in all macroeconomics is consumption function. The consumption • function shows the relationship between the level of consumption expenditure and the level of disposable personal income.This concept was introduced by Keynes and he derived that there is a stable relationship between consumption • and income. The consumption function graph is shown in the figure below as per the data given below.

Disposable income Net saving (+)or dissaving (-) Consumption

A 24,000 -110 24,110

B 25,000 0 25,000

C 26,000 +150 25,850

D 27,000 +400 26,600

E 28,000 +760 27,240

F 29,000 +1,170 27,830

G 30,000 +1,640 28,360

Table 3.2 Consumption data

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28000

26000

24000

22000

20000

0 20,000 22,000 24,000 26,000 28,000 30,000

Consumption

45o

Saving

Consumptionfunction

E

E”

E’

FG

AB

C

C

D

Dl

Break-even point

Con

sum

ptio

n ex

pend

iture

s

Disposable income

Fig. 3.1 Plot of consumption function

In the above graph, X axis shows the disposable income and Y axis shows the consumption expenditure. Each • of the income consumption combination is represented by a single point and then the points are connected by a smooth curve.Break-even point:• In the figure, both X and Y axes are at the same distance from the 45 degree line. At any point from that line, the distance up from horizontal line and vertical line remains same.The 45 degree line tells that whether the consumption spending is equal, greater than or less than the level • of disposable income. The Break-even point on the consumption schedule that intersects the 45 degree line represents the level of disposable income at which households just break even.The Break-even point B, where the consumption is exactly equal to the disposable income, the household is • neither a borrower nor a saver.The relationship between consumption and income can be seen by examining the thin black line from E’ to E.• At income 28,000, the level of consumption is 27, 240. We can see that if the consumption is less than income, • then the consumption function lies below the 45 degree line.The 45 degree line tells us that to left of point B, the household is spending more than its income. Excess of • consumption over income shifts the curve to the left of 45 degree line.

3.1.1 Marginal Propensity to Consume (MPC)

In general, we know that changes in income make the changes in consumption. This concept is called as Marginal • Propensity to Consume or MPC.The MPC is the extra amount that people consume when they receive an extra dollar of disposable income. • Propensity to consume means the desired level of consumption. From the table below, we can find the MPC:

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Disposable Income in Rupees Consumption MPC

A 24,000 24,110

B 25,000 25,000 890 / 1000 = .89

C 26,000 25,850 850 / 1000 = .85

D 27,000 26,600 750 / 1000 = .75

E 28,000 27,240 640 / 1000 = .64590 / 1000 = .59

F 29,000 27,830

G 30,000 28,360 530 / 1000 = .53

Table 3.3 Marginal propensity to consume

28000

26000

24000

22000

20000

0 20,000 22,000 24,000 26,000 28,000 30,000

45o

$ 1,000

$ 850

E

E”

E’

FG

AB

C

C

D

Dl

Con

sum

ptio

n ex

pend

iture

s

Disposable income

Fig. 3.2 The MPC curve

The figure shows how to calculate MPC graphically. Near point B and C, a little right triangle is drawn. The • slope of consumption function, which measures the change in consumption per dollar change in disposable income, is the marginal propensity to consume.

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3.2 InvestmentThis part focuses on Gross Private Domestic Investments. The major types of gross private investments are in buildings and infrastructure, business fixed equipments, software and additional inventory and so on.

Business will earn profit if the revenue will be more than the cost of investments.• Investment has two main elements - revenue and cost.•

RevenuesIf the firm sells more products, then the revenue of that firm will be more. The selling capacity of the firm is • more if it focuses on proper investment and planning.The overall output or GDP will be an important determinant of investment. That means investment depends • upon the revenues generated by overall economic activity.

CostThe second important determinant of level of investment is the total cost of investment.• Investors basically raise the funds by borrowing for buying capital goods. There is a cost of borrowing, which • is the interest rate on borrowed funds. Interest rate is the price paid for borrowing money for a period of time.Taxes can have major effects on investments. Sometimes the government gives tax breaks to particular activities • or sectors.

Investment and demand curveTo show the relationship between interest rate and investment, economist use a schedule called investment • demand curve.Changes in the interest rate should have an effect on the investment. A fall in the interest rate should decrease • the cost of investment.The inverse relationship between investment and rate of interest is shown in the figure.•

Rat

e of

Inte

rest

Planned Investment

I1 I2

R1

R2

MarginalEfficiencyofCapital

Fig.3.3Marginalefficiencyofcapital

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3.3 Money SupplyLike other commodity, money is also governed by demand and supply forces. It is valuable as long as it is used for purchasing goods and services.

There are some objects which are used for multiple purposes; money falls under the category of such objects. • For example, money is used for purchasing car, TV or any other commodities; similarly it is used for medical care, education, insurance and other services.Similarly there are many functions of money which can be studied under the following points:•

Medium of exchange �Value measurement �

Medium of exchange: Previously, in barter system, goods were exchanged for goods. For example, if someone wants rice and he has sugar and other person wants sugar but he has rice then both of them will exchange some part of their commodity to get the other good. If the person doesn’t get someone who has rice, then it is difficult for him to get rice. So to resolve this problem, money proves to be the most convenient medium of exchange.

Value measurement: Accustomed to exchange things for money, people gradually learned to appraise all commodities in terms of money, and to adjust all exchanges by comparing the money values. Thus, money provides common denominator to all types of goods and services.

3.3.1 Exogenous and Endogenous Process of Money SupplyExogenous and endogenous process of money supply are explained below

Exogenous process of money supply: If the money supply is determined by Central Bank then it is called as • Exogenous Money Supply.Endogenous process of money supply• : In endogenous process of money supply, the money comes into existence as needed by real economy, which means the bank can raise or drain money as per the demand of money. For example, if there is change in economic activity, then there must be a change in the interest rate on money deposited in bank.

3.3.2 High Powered Money and Money SupplyHigh Powered Money is the sum of commercial bank reserved and the currency held by public. Money supply varies directly with changes in monetary base, and inversely with the currency and reserve ratio.

The High Powered Money (H) is the sum total of currency (C), required reserves (RR) and excess reserves (ER);H = C + RR + ER

The Money Supply (M) consists of deposits of commercial banks (D) and currency (C) held by the public;M = D + C

The relationship between High Powered Money and Money Supply can be expressed by taking the ratio of both. So;

M/H=(D+C)/(C+RR+ER) (1)

Divide numerator and denominator of right hand side equation (1) by D;M/H=[(D+C)/D]/[(C+RR+ER)/D]

OrM/H=(1+C/D)/(C/D+RR/D+ER/D) (2)

Reserve Ratio: It is the amount of money or liquid assets that the Commercial Bank must hold to customer deposit i.e. the amount that the bank surrenders with the central bank.

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By substituting Cr for C / D, RRr for RR / D and ERr for ER / D equation (2) becomes;M/H=(1+Cr)/(Cr+RRr+ERr)

Thus, the High Powered Money becomes;H=[(Cr+RRr+ERr)]/[(1+Cr)]XM

Hence, The Money Supply is;M=[(1+Cr)]/[(Cr+RRr+ERr)]XH

3.3.3 Measures of Money Supply in IndiaThere are four measures of money supply in India, denoted by M1, M2, M3 and M4.

M1 is the first measure of money supply. It consists of :• Currency with the public which includes coins and notes of all denomination �Demand deposit with commercial and cooperative bank �Other deposits with RBI which includes current deposits of foreign central bank, financial institutions and �so forth.

M2 is the second measurement of money supply. It includes:• M1 plus post office savings and bank deposits �Majority people of rural and urban area prefer to save in post office rather than bank because of the safety �purpose.

M3 is the third measure of money supply in India. It consists of:• M1 plus time deposits with commercial and cooperative banks, excluding interbank time deposits. �

M4 is the fourth measure of money supply consisting:• M3 plus total post office deposits comprising time deposits and demand deposits as well. �

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SummaryThis chapter covered the meaning and definition of consumption and its functions. The entire consumption • function is derived with the help of graph and it also elaborated the term Breakeven Point; where total consumption is equal to the disposable income.Next it discussed the marginal propensity to consume, which is the extra amount that people consume when • they receive an extra dollar of disposable income.Then it discussed the term investment and also terms used in it - revenue, and cost. If the firm sells more products • then the revenue of that firm will increase. The selling capacity of the firm is depends on proper investment and planning. Cost of investment is another important element of investment.Money supply is categorised as exogenous and endogenous money supply. The High Powered Money is the • sum total of currency, required reserves and excess reserve.Lastly, it covered the four types of money supply in India, denoted as M1, M2, M3 and M4.•

ReferencesHoldsworth, J. T., 2009. • Measure of Value. [Online]Available at: <chestofbooks.com/finance/banking/Money-And-Banking-Holdsworth/10-Measure-Of-Value.html> [Accessed 15 November 2010].Components of Aggregate Expenditure: Consumption, Investment, Government Purchases, and Net Exports,• [Online] Available at:<http://business.baylor.edu/Tom_Kelly/2307ch9.htm> [Accessed 21 August 2012]Barro, R. J., 2008. • Macroeconomics: A Modern Approach. Cengage Learning.Jhingan, M. L., 2009. • Managerial Economics Money Supply. Vrinda Publications Pvt. Ltd, New Delhi.Economics Consumption and Investment• , [Video Online] Available at: <http://www.youtube.com/watch?v=vw5W33QwuJM>[Accessed 21 August 2012]Economics Consumption and Investment 2• , [Video Online] Available at: <http://www.youtube.com/watch?v=zk8WEO2XrgY&feature=relmfu>[Accessed 21 August 2012]

Recommended ReadingDr. Mithani, D. M., 2008. • Business Cycle. Institute of Business Study and Research. Himalaya Publishing House Pvt. Ltd.Samuelson, P. A., 2002. • Economics, Massachusetts Institute of Technology, Tata McGraw-Hill Publishing Co.Gupta, S. B., 2009. • Monetary Economics, Money and Payment System. S. Chand & Company, New Delhi.

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Self AssessmentWhich of the following is a durable good?1.

Fuela. Furnitureb. Medical care c. Foodd.

The point where disposable income is exactly equal to the consumption is known as _________.2. Saturation pointa. Equilibrium point b. Break-even point c. Marginal pointd.

Changes in income make the changes in consumption. This concept is called ___________.3. Marginal Propensity to Consume a. Marginal Returnb. Marginal Utilisationc. Marginal Costd.

Which of the following is a gross investment?4. Investment in infrastructurea. Investment in foodb. Investment in share marketc. Investment in foreign traded.

M2 money supply includes;5. Currency with the public which includes coins and notes of all denomination a. Demand deposit with commercial and cooperative bankb. M1 plus post office savings and bank depositsc. Deposits with RBId.

Exogenous money supply is determined by which of the following?6. The Central Banka. The Cooperative Bank b. The Federal Bankc. The Post Officed.

Which of the following is the schedule used by economist to show the relationship between interest rate and 7. investment?

Investment demand curve a. GDPb. MPC curvec. Disposable incomed.

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Investment has which two main elements?8. Revenue and costa. Per capita income and per capita cost b. Income and profitc. GNP and GDPd.

Which of the following is not the category of consumption?9. Durable goodsa. Nondurable goods b. Servicesc. Giffen goodsd.

Excess reserves is required to calculate which of the following?10. High Powered Money Supply a. NNPb. GDPc. GNPd.

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Chapter IV

Business Cycle and Inflation

Aim


define the meaning and concept of business cycle•

explain the phases of business cycle by giving the real time example•

describe the basic concept of inflation•

Objectives


explain business cycle with the help of real time example•

describe the basic concept of inflation including price and money inflation•

elucidate the causes of inflation and it various measurements•

Learning outcome


understand the basics of business cycle and its phases•

enlist the causes of inflation and its impact on business•

identify various measurements developed by the government to control inflation•

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4.1MeaningandDefinitionofBusinessCycleBusiness Cycle is nothing but the fluctuation of national output, income and employment. This fluctuation usually sustains for a period of more than 2 to 10 years.

There are four phases of business cycle as shown in the figure:Trough• , when the output level reaches at the bottomExpansion,• when the economic real output is rising from troughPeak,• when the output level reaches to a high level that means the economy is at higher positionRecession,• when the economic output is declining from the peak phase.

Recession

Recession

Peak

Bus

ines

s con

ditio

ns

PeakPeak

Trough

Trough

Constsraction Expa

nsion

Fig. 4.1 Phases of business cycle

4.1.1 Real Example of the Phases of Business CycleIn the year of 2008, America’s financial system faced a severe credit crunch, which gave rise to a worst recession in the U.S. This was a serious risk for U.S. financial market as huge credit and assets bar collapsed.

All the sectors, starting from automobile to the real estate, were affected severely because of recession. Many economists consider this to be the worst financial crisis since the Great Depression of the 1930s. It contributed to the failure of key businesses, decline in consumer wealth, which is estimated in the hundreds of billions of U.S. dollars, crash in substantial financial commitments incurred by governments, and a significant decline in economic activity.

Table below shows some ‘turning point dates’ of the current economy:

Peak Dates Trough Dates

• September 1984 • October 1985

• November 1989 • September 1993

• October 1995 • November 1996

• November 1997 • April 1999

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• December 2000 • February 2005

• March 2008 • May 2009

Table 4.1 Turning point dates of current economy(Source: 2010 Federal Reserve Bank of St. Louis)

4.1.2 Characteristics of Recession in Business CycleFollowing are few characteristics of recession:

Consumer purchases decline sharply, even if the inventories of business increase unexpectedly.• The unemployment rate is higher because organizations opt for cost cutting by decreasing labor count.• Inflation falls as the demand for crude materials declines. Wages and prices of services are unlikely to • decline.Business profit falls sharply in recession. Common stock prices usually fall as investors sniff a business • downturn.However, because the demand for credit falls, interest rates also generally fall in recession.•

4.2InflationThe rate at which the general level of prices for goods and services rises and subsequently, purchasing power falls is called as inflation. We can also say that it is the persistent increase in the general price level or persistent decline in the real income of people.

Economists have categorized inflation into two main parts:• Price Inflation �Money Inflation �

Both price and money inflation are interrelated, that means they come under cause and effect relationship. Price • inflation is the effect of money inflation.When the supply of money increases, the price level of goods and services will also increase simultaneously.•

Now the question arises - how and why the supply of money increases?

The supply of money may increase either by additional printing of currency as per the demand of the government to meet the expenditure or due to the loans and aids from world institutions like the World Bank.

Other sources of additional money supply are foreign exchange, inflows in the form of capital, like FDI (Foreign Direct Investment) and so on.

4.2.1CausesofInflationThe major causes of inflation are:

Excess Money Supply• Demand Pull Inflation• Cost Push Inflation•

Excess money supplyWhen money inflation leads to price inflation, the phenomenon is known as monetarism.• For a very long time, money supply was accepted as the single most important cause of price rise, because it • can be directly linked with increase in aggregate demand.

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DemandpullinflationDemand pull inflation occurs when the demand is more in comparison to the supply.• Due to increased demand, the price of the commodity also increases, which causes inflation. The figure shows • the graph of demand pull inflation.

In the Short Run

Price

Real GDPASO

AggregatePrice LevelGDP deflator

AD1AD0

Y0 Y1 Real GDPAggregate Output

r0

r1

Fig.4.2Demandpullinflation

In demand pull inflation, the GDP (national output) is more which helps in reducing unemployment problem • to some extent.

ReasonsfordemandpullinflationMajority of commercial firms of a nation offer employment to fulfill the demand for goods and services. So the • aggregate demand rises, which pushes the commercial firms to employ more labor force to derive maximum output.

CostpushinflationCost push inflation is the other side of price determination in supply. It is a situation where demand remains • unchanged and still the price increases.This may happen due to change in supply pattern, if the producer continues to produce the same output even • if the input prices changes.Increase in costs of production cause the aggregate supply curve to shift to left. This may occur if there is increase • in the costs of the factor inputs or if there is a supply shock such as a drought.When a firm’s input cost increases, it will hike the prices of output to maintain the level of their profits. This may • result in the fall of real incomes of the owners. In an attempt to maintain their real income, labor will demand higher money wages and this will in turn raise costs.

Primereasonsforcostpushinflationcouldbe:Increases in factor prices, e.g., oil price increase• Increase in wage settlements in excess of any increase in productivity• Devaluation or depreciation of currency leading to an increase in import prices• Rise in interest rate which increases the cost of borrowing• Indirect taxation or the removal of subsidies.•

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Oil Price IncreasesAS shifts to 1Price level Increases

SRAS1

SRASAggregatePrice Level

ADAD0

Aggregate Output Y1 Y0=Ye Real GDP

P0

P1GDP deflator

Fig.4.3Costpushinflationcurve

4.2.2MeasurementofInflationAs far, we discussed that inflation is nothing but taking more amount of money from your pocket and adding less quantity of goods to consumption basket with or without any improvement in the quality and quantity of goods.

So the government uses a common term to measure the inflation called inflation rate. Other way of measurement used is called as indices.

Price index is a numerical measure which is designed to compare that how the price of some class of goods and services differ between time periods or geographical locations. It is the ratio of Current Year’s Price and Base Year’s Price.

PriceIndex=[CurrentYear’sPrice/BaseYear’sPrice]X100

Some of the important price indices are as mentioned below:Producer Price Index (PPI)

Producer Price Index measures the average change in prices received by domestic producers for their output.• The PPI concentrates on the area of industry based production and stage of processing based companies.• It keeps track of the prices of foods, metals, oil and gases, and many other commodities except the price of • services.It has been using the Standard Industrial Classification system to collect and record the data for many years.•

Wholesale Price Index (WPI)When inflation is calculated on the basis of wholesale prices of a wide variety of goods, it is called as Wholesale • Price Index (WPI).In India, WPI is available on weekly basis, while in U.S. WPI has already been replaced by PPI.•

Consumer Price Index (CPI)It measures the prices of selected goods purchased by a “typical consumer.”• The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging • them; the goods are weighted according to their importance.Changes in CPI are used to assess price changes associated with the cost of living.•

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SummaryBusiness Cycle is nothing but the fluctuation of national output, income and employment.• The rate at which the general level of prices for goods and services rises and subsequently, purchasing power • falls is called as inflation.When money inflation leads to price inflation, the phenomenon is known as monetarism.• Demand pull inflation occurs when the demand is more in comparison to the supply• Due to increased demand, the price of the commodity also increases, which causes inflation• Producer Price Index measures the average change in prices received by domestic producers for their output• When inflation is calculated on the basis of wholesale prices of a wide variety of goods, it is called as Wholesale • Price Index (WPI).

ReferencesDevan, J., Rowland, M. & Woetzel, J., 2009. A • Consumer Paradigm for China. [Online]Available at: <http://mkqpreview1.qdweb.net/A_consumer_paradigm_for_China_2429> [Accessed 17 November 2010].Roubini, N., 2008. • Stern School of Business, New York University,[pdf] Available at: <msnbcmedia.msn.com/i/msnbc/sections/tvnews/nightly%20news/roubini022608.pdf> [Accessed 17 November 2010].Hoag, A. J. & Hoag, J. H., 2006• . Introductory Economics. World Scientific.Lipsey, R. G. & Chrystal, K A., 2007. • Economics. Oxford University PressThe Business Cycle: The business cycle and how it may be driven by emotion• , [Video Online]. Available at: <http://www.youtube.com/watch?v=TXrOpjG4dUs> [Accessed 22August 2012].Business Cycle Theory - Introduction to Austrian Economics, 7of11• .[Video Online]. Available at: <http://www.youtube.com/watch?v=Bxq_mhdYeBM> [Accessed 22August 2012].

Recommended ReadingGeetika, 2008. • Managerial Economics, Money Supply and Economics. Tata McGraw-Hill Publishing Co., New Delhi.Jhingan, M. L., 2009. • Managerial Economics, Money Supply. Vrinda Publications Pvt. Ltd., New Delhi.Samuelson, P. A., 2002. • Economics. Massachusetts Institute of Technology. Tata McGraw-Hill Publishing Co.

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Self AssessmentThe phase when the economic output is declining is called as __________.1.

peaka. recessionb. contraction c. expansiond.

Business profits falls due to____________.2. high price a. recessionb. low supplyc. credit crunchd.

When money inflation leads to price inflation, the phenomenon is known as ____________.3. monetarism a. contractionb. credit crunchc. Supply inflationd.

Which of the following statements is true?4. Demand pull inflation occurs when demand is more in comparison to the supply.a. Money inflation occurs when demand is more in comparison to the supply.b. Cost inflation occurs when demand is more in comparison to the supply.c. Supply inflation occurs when demand is more in comparison to the supply.d.

Which of the following is not a cause of inflation?5. Demand Pull Inflationa. Cost Push Inflationb. Excess Money Supplyc. Maximum Employmentd.

Price inflation is the effect of ____________.6. money inflation a. demand inflation b. cost inflationc. supply inflationd.

What measures the price of a selection of goods purchased by a typical consumer?7. WPI a. CPI b. PPI c. NNPd.

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The average change in prices received by domestic producers for their output is known as __________.8. WPI a. CPI b. PPIc. NNPd.

___________ is using the Standard Industrial Classification system to collect and record the data for many 9. years.

WPI a. CPI b. PPIc. NNPd.

Which of the following is available on weekly basis?10. WPI a. CPI b. PPI c. NNPd.

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Chapter V

Monetary Policy

Aim


define monetary policy with the help of real time examples•

enlist various monetary measurements for calculating the financial condition of a nation•

elucidate the relationship between monetary policy, target of money supply•

Objectives


evaluate the relationship between money supply and inflation•

enlist objectives of monetary policy•

explain the tools of monetary policy•

Learning outcome


understand the concept of money supply and rotation of money•

identify the tools of monetary policy•

understand the variations in inflation and its various measurements•

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5.1MeaningandDefinitionofMonetaryPolicyMonetary policy refers to the measurement of growth rate and size of money supply; this process is carried out by the central bank.

Monetary policy is a way in which the government controls economy. It affects the interest rate. If money supply is too fast then the inflation will rise and if it goes too slow then the nation’s output will be less, hence GDP will be low. So there must be controlled money supply to maintain the economy a nation.

For example, if the salary of the employees of a particular organisation is increased by 20%, then they may start thinking about purchasing new TV, laptops and so on. Fulfilling this increased demand will take some time and in between this gap, the equation of supply and demand gets imbalanced as demand is more than the supply. This shortage of supply leads to price rise of the products, which is nothing but inflation.

In short, Increased Money Supply > Increase in the Demand of Product > Increase in Price > Inflation

5.2 How to Achieve the Goals of Monetary Policy?Some of the major goals of monetary policy are:

Rise in employment• Economic growth• Low inflation• Balanced payments•

All these goals are based on the operation of the central bank. It has two main tools to implement the monetary policy:

Open Market Operation• Discount Window•

Open market operationIt is the buying and selling of the government bonds by the central bank. Government buys this bond to pump money into the system which lowers the interest rate. However, if the bonds are sold, the interest rate becomes high as money is taken out from the system.

Discount windowHere, the commercial banks borrow reserves from central bank at a discount rate.• This rate is set below the market rate; so that the banks can vary in the credit conditions, there by affecting the • money supply.

Tools of Monetary Policy 1. Open Market Operation2. Discount Window

Goals of Monetary Policy 3. Rise in Employment4. Economic Growth5. Low Inflation6. Balance Payment

Target of Monetary Policy 1. Money Supply2. Interest Rate

Control to get To achieve

Fig. 5.1 Flowchart for the process of monetary policy(Source: www2.bc.edu)

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5.3 Monetary MeasuresVarious monetary measures are:

Bank Rate• Repo Rate• Reverse Repo Rate• Cash Reserve Ratio (CRR)•

Bank rateA bank rate is the interest rate that is charged by a country’s central or federal bank on loans and advances to • control money supply in the economy and the banking sector.This is typically done on a quarterly basis to control inflation and stabilize the country’s exchange rates. A • fluctuation in bank rates triggers a ripple-effect as it impacts every sphere of a country’s economy.For example, the prices in stock market tend to react to interest rate changes. A change in bank rates affects • customers as it influences prime interest rates for personal loans.In India, as per RBI (Reserve Bank of India) norms, the bank rate is retained at 6 percent.•

Repo rateWhenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the rate at which • banks borrow rupees from RBI.A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases, • borrowing from RBI becomes more expensive.

Reverse repo rateReverse repo rate is the rate at which RBI borrows money from banks. Banks are always happy to lend money • to RBI since their money is in safe hands with a good interest.An increase in reverse repo rate can cause the banks to transfer more funds to RBI due to attractive interest • rates.An increase in reverse repo rate can prompt banks to park more funds with the RBI to earn higher returns on • idle cash. It is also a tool which can be used by the RBI to drain excess money out of the banking system.

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Cash reserve ratioCash Reserve Ratio is a bank regulation that sets the minimum reserves each bank must hold to customer • deposits and notes.It influences the country’s economy, borrowing and interest rate.• Currently, the CRR in India is 5. 75 percent to 6 percent•

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SummaryMonetary policy refers to the measurement of growth rate and size of money supply; this process is carried out • by the central bank.Monetary policy is a way in which the government controls economy.• If money supply is too fast then the inflation will rise and if it goes too slow then the nation’s output will be • less, hence GDP will be low.A bank rate is the interest rate that is charged by a country’s central or federal bank on loans and advances to • control money supply in the economy and the banking sectorWhenever the banks have any shortage of funds they can borrow it from RBI. • Repo rate is the rate at which banks borrow rupees from RBI.• Reverse repo rate is the rate at which RBI borrows money from banks.• Cash Reserve Ratio is a bank regulation that sets the minimum reserves each bank must hold to customer • deposits and notes.

ReferencesMonetary Policy, • [Online] Available at: <www.finpipe.com/monpol.htm> [Accessed 18 November 2010].Reserve Bank of India• . [Online] Available at: <www.rbi.org.in/scripts/NotificationUser.aspx?Id=5602&Mode=0> [Accessed 18 November 2010].Taylor, J. B., 2001. • Monetary Policy Rules. University of Chicago Press.Arestis, P., 2005. • The New Monetary Policy: Implications And Relevance. Edward Elgar PublishingProfessor Shiller, 2012. • Monetary Policy.[Video Online].Available at: <http://www.youtube.com/watch?v=_SpIaGTq0u8> [Accessed 23 August 2012].Fiscal and Monetary Policy Overview• , [Video Online]. Available at: <http://www.youtube.com/watch?v=5gvFwDPaOQ0&feature=fvwrel> [Accessed 23 August 2012].

Recommended ReadingGeetika, 2008. • Managerial Economics, Monetary Policy. Tata McGraw-Hill Publishing Co., New Delhi.Jhingan, M. L., 2009. • Managerial Economics, Monetary Policy. Vrinda Publications Pvt. Ltd., New Delhi.Samuelson, P. A., 2002. • Economics, Central Banking and Monetary Policy. Massachusetts Institute of Technology. Tata McGraw-Hill Publishing Company.

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Self AssessmentMeasuring the growth rate and size of money supply by the central bank is known as _______.1.

Monetary Policy a. Fiscal Policyb. Economic Policyc. CRRd.

Which of the following is not the goal for monetary policy?2. Rise in employment a. Economic Growthb. Low Inflationc. Gross Domestic Productd.

Government buys the bond to pump money into the system. This is known as __________3. open market operation a. discount windowb. net national incomec. income of governmentd.

The commercial bank borrows reserves from central bank at a discount rate. It is known as _____________.4. discount windowa. open market operationb. discount ratec. bank Rated.

Which of the following is the target for monetary policy?5. Discount Windowa. Open Market Operation b. Low Inflationc. Interest Rated.

Monetary policy refers to the measurement of growth rate and size of money supply; this process is carried out 6. by the___________.

central bank a. international bankb. WMFc. world bankd.

The rate at which banks borrow rupees from RBI is called ________.7. bank ratea. reserve ratiob. cash reserve ratio c. repo rated.

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Which of the following influences the country’s economy?8. CRR a. GDPb. GNPc. Reverse Repo Rated.

A reduction in the __________will help banks to get money at a cheaper rate9. CRR a. GDP b. reverse repo ratec. repo Rated.

Bank regulations which set minimum reserves each bank must hold to customer deposits and notes is called 10. ____________.

CRR a. GDPb. repo ratec. reverse Repo Rated.

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Chapter VI

Fiscal Policy

Aim


explain fiscal policy in terms of government expenditure and taxation•

determine the measurement of various fiscal policies and its applications•

explain balanced budget in terms of equation•

Objectives


define the fiscal policy and its applications•

enlist the techniques of fiscal policy•

formulate the equation for balanced budget•

Learning outcome


understand the concept of fiscal policy•

identify various techniques of fiscal policy•

understand balanced budget in terms of income and expenditure•

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6.1MeaningandDefinitionofFiscalPolicyFiscal policy is made by the government to control its expenditure, supply of money and taxes. Government expenditure comes in two distinct forms:

Government spending on various goods and services like purchasing of tanks, construction of roads and railways, • salaries for judges and so on.Government transfers the payments to the targeted group such as elderly or unemployed people to boost them • up.

Taxation is another part of fiscal policy. It affects the overall economy in two ways:Tax affects the prices of goods and factors of production and thereby affecting the incentives and also the • behavior of an economy.Tax tends to affect the amount people spend on goods and services as well as amount of private saving. Private • consumption and saving have important consequences on investment and output in short run and long run.

If the government budget shows that estimated expenditure is more than the estimated income, then it becomes necessary to formulate fiscal policies to bring in balance in such adverse situation. Here, balanced situation means total expenditure is equal to total income. For this government can use some of the techniques of fiscal policy mentioned below.

6.2 Techniques of Fiscal PolicySome important techniques of fiscal policy are as follows:

Taxation policy• Public expenditure• Deficit financing policy• Public Debt Policy•

Taxation policyBy amendment in Indian Tax Law of 1961, the Government of India has the power to make new taxation policy • according to the current Indian economic situation.Either government can increase the tax rate or decrease exemption for collecting more tax for previous year • income.

Public expenditurePublic expenditure policy is very useful in reducing the government expenditure. Government divides total • expenditures into two major categories:

Development expenditure �Non - development expenditure. �

With this policy, government encourages only development expenditure and tries to reduce non development • expenditure.

DeficitfinancingpolicyIf above two equipment does not work to create balance in government budget, government can get loan from • central bank to adjust deficit.For this, the RBI has to issue new currency notes. But this decision should be taken very carefully because • increasing trend of deficit financing will decrease the value of currency in world market and it will increase the prices of commodities, which, ultimately, will give rise to inflation.

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Public debt policyPublic debt means, loan is taken by government to fulfill government expenditures. Government should make this policy very seriously. If there any other source, then government should use to pay government expenditure or reducing expenditure is better than taking loan. Sometime, under the pressure of foreign creditor, government of India has to take many decisions which are against public interest.

6.3 Fiscal Policy during Economic BoomDuring the time of economic boom there is a surplus in the budget. In this surplus budget, the government revenues exceed expenditure.

The policy of surplus budget is followed to control inflationary pressure within the economy. It may be through • increased taxation or reduction in government expenditure or both. This is explained with the help of a graph below.The economy is at initial position named E1. Suppose the government expenditure is reduced by ∆G, so that • the total spending function will be C + I + G which shifts downward to C’ + I’ +G’.Now E is the new equilibrium position which shows that the income has declined to OY from OY’ as a result • of reduction in expenditure by E1B.

} ∆GE

B

45o

AC

Income

Expe

nditu

re

0

C + 1 + G

C + 1 + G

Y1Y

E1

Fig. 6.1 Fiscal policy in economic boom

6.4 Balanced BudgetAnother concept of fiscal policy is balanced budget. In this policy, increase in both taxes (∆T) and government • expenditure (∆G) is of an equal amount.The balanced budget theorem is based on combined operation of tax multiplier and government expenditure • multiplier. Here the tax multiplier is smaller than government expenditure multiplier.

The government expenditure multiplier is,∆Y=(1/1-c)/∆G

Or∆Y/∆G=1/(1-c) (1)

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Where,∆G = change in government expenditure∆Y = change in income

Equation (1) shows that the change in income (∆Y) will equal the multiplier by (1 / 1-c) times the change in government expenditure.

The tax multiplier is,∆Y=-c∆T/(1-c)

∆Y/∆T=-c/(1-c) (2)

Where∆T = change in Taxc = marginal propensity to consume

Equation (2) shows that the change in income (∆Y) will equal the multiplier by (1 / 1-c) the product of the marginal propensity to consume (c) and the changes in taxes (∆T).

The balanced budget can be explained by combining the equation (1) and (2), i.e.b=∆Y/∆G+∆Y/∆T=1/(1-c)+[-c/(1-c)]=(1-c)/(1-c)=1

As ∆G=∆T, income will change by amount equal to change in government expenditure and taxes.

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SummaryFiscal policy is made by the government to control its expenditure, supply of money and taxes.• Tax affects the prices of goods and factors of production and thereby affecting the incentives and also the • behavior of an economy.Tax tends to affect the amount people spend on goods and services as well as amount of private saving.• By amendment in Indian Tax Law of 1961, the Government of India has the power to make new taxation policy • according to the current Indian economic situation.Public expenditure policy is very useful in reducing the government expenditure.• Public debt means, loan is taken by government to fulfill government expenditures.•

ReferencesFiscal Policy• . [Online] Available at: <www.svtuition.org/2010/03/fiscal-policy.html> [Accessed 19 November 2010]. De, S., 2012. • Fiscal Policy in India: Trends and Trajector. Available at: <http://finmin.nic.in/workingpaper/FPI_trends_Trajectory.pdf> [Accessed 24 August 2012]Langdana, F., 2009. • Macroeconomic Policy: Demystifying Monetary and Fiscal Policy. Springer.Jhingan, M. L., 2009. • Managerial Economics, Money Supply. Vrinda Publications Pvt. Ltd, New Delhi.Fiscal Policy Explained Simple Way• , [Video Online] Available at: <http://www.youtube.com/watch?v=zgH4D1H0Ti4> [Accessed 24 August 2012]Monetary and Fiscal Policy,• [Video Online].Available at: <http://www.youtube.com/watch?v=ntxMOKXHlfo> [Accessed 24 August 2012]

Recommended ReadingDr. Mithani, D. M., 2008. • Managerial Economics (Theory & Application). Institute of Business Study and Research. Himalaya Publishing House Pvt. Ltd.Samuelson, P. A., 2002. • Economics. Massachusetts Institute of Technology. Tata McGraw-Hill Publishing Co.Gupta, S. B., 2009. • Monetary Economics. Money and Payment System, S. Chand & Company, New Delhi.

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Self AssessmentSpending on various goods and services like purchasing of tanks, construction of roads and railways, salaries 1. for judges is known as ____________.

government expenditure a. taxationb. spendingc. wagesd.

Which of the following is affected by tax?2. Prices of goods a. Inflationb. Gross Domestic Productc. CRRd.

Which of the following is a balanced situation in economy?3. Saving is equal to incomea. Total expenditure is equal to total income b. GDP = GNPc. saving is equal to spendingd.

Which of the following is used to reduce government expenditure?4. Taxation policya. Budget deficit policyb. Public expenditure policy c. Deficit policyd.

What will happen in surplus budget?5. Government revenues will exceed expenditure a. Revenue will exceed profitb. Personal income will exceed expenditurec. Per capita income will exceed expenditured.

How inflationary pressure can be controlled?6. By increasing tax a. By decreasing taxb. By increasing consumptionc. By decreasing consumptiond.

In which of the following concept, increase in both taxes and government expenditure is of an equal amount?7. Taxation policya. Budget deficit policyb. Public expenditure policy c. Balanced budgetd.

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Which policy is very useful in reducing the government expenditure?8. Public expenditure a. Development expenditure b. Educational expenditurec. Growth expenditured.

_____________ means, loan is taken by government to fulfill government expenditures9. Public debt a. Public expenditure b. Development expenditure c. Educational expenditured.

____________ affects the prices of goods and factors of production and thereby affecting the incentives and 10. also the behavior of an economy

Taxa. Incomeb. Inflationc. Expenditure d.

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Chapter VII

Macroeconomic Models

Aim


recognise macroeconomic models•

elucidate the role and importance of macroeconomic models•

explain the broad types of the macroeconomic models•

Objectives


enlist names of different macroeconomic models•

describe classical macroeconomic model•

explain simple classical model•

Learning outcome


identify simple classical and classical macroeconomic model•

understand the Keynesian model•

understand IS/LM, IS/MP models•

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7.1 IntroductionUsing macroeconomic models we can analyze what happens when the government increases consumption, when the central bank increases the target interest rate and when domestically produced goods do well in foreign markets. We can also understand important observations of the economy, such as cyclical fluctuations in growth, correlation between unemployment and inflation and the relationship between interest rates and foreign exchange rates.

Macroeconomics is not an exact science such as physics. No one knows exactly how the macroeconomic variables are related. Instead, there exist a number of models that try to explain various observations and relationships between macroeconomic variables. Unfortunately, not all of these models consistent - one model may predict that unemployment will fall if the central bank lowers the target interest rate while another may claim that such a change will not affect unemployment.

This type of problem is something you have to get used to and accept. Economics is not a subject where you can perform an experiment to find out what is really “true”. Observed phenomena may have different explanations in different models and different models will lead to different predictions of macroeconomic variables. If you conclude that “An increase in x will lead to an increase in y”

One model that is very popular in virtually all basic courses in macroeconomics all over the world is the so-called neo-classical synthesis. As the name suggests, this is a combination or a synthesis of two models, namely the classical model and the Keynesian model. In short, the neo-classical synthesis claims that the Keynesian model is correct in the short term while the classical model is correct in the long run. Note that there are actually many minor variations of the neoclassical synthesis.

7.2 Common assumptionsAll models require a number of assumptions to understand some concepts. In this section we will describe the assumptions.

7.2.1 Unemployment and hours worked are directly relatedWe may see an increase in the labour force (for example from immigration) that is larger than the increase in employment which would lead to an increase in both hours worked and unemployment but we disregard this possibility.

7.2.2 The central bank has complete control over money supply. Money supply is equal to the money multiplier times the monetary base. We can assume that the money multiplier is constant and since the monetary base is completely under the control of the central bank, the central bank will control the money supply.

7.2.3 Monetary policy = change in money supplyThe central bank actually has other monetary policy instrument apart from being able to determine the money supply. The most important one is the target interest rate for the overnight market.

7.2.4 There is just one interest rate. Including different interest rates with different maturities would complicate the models but it would not buy you very much. Since interest rates with different maturities are highly correlated, they typically move in the same direction.

7.2.5 Exchange rateIn all models, we can assume that the exchange rate is flexible. Furthermore, we assume that the exchange rate is determined by the ratio of the domestic price level to the foreign price level. If, for example, domestic prices increase by 10% while foreign prices are constant, the domestic currency will depreciate by 10% against the foreign currency. With this assumption, exports and imports may be assumed to be independent of the domestic price level.

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If domestic prices increases by 10% while the currency loose 10%, the price of domestically produced goods abroad will be unchanged.

7.2.6 Capital FlowsIn most models, the domestic interest rate is not affected by foreign interest rates. With free capital flows, this is a very unreasonable assumption. If we assume the domestic interest rate increase against the foreign interest rates, capital would flow into our country which would drive down the domestic interest rate again.

Most reasonable models in which the domestic interest rate is affected by foreign interest rates are more complicated. To understand such models, you must first understand the models where this complication does not arise. Also, the predictions from models where the domestic interest rate is not affected by foreign interest rates are fairly similar to the more realistic models which allows for capital flows.

7.3 Classical Models - The Role of Aggregate SupplyThe foundation for the Classical Model is three basic ideas:

Output is produced by capital and labour, • Capital is fixed in the short run, and• Supply and demand for labour determine the amount of labour hired.•

The third point implies that there is no unemployment. This may or may not be a useful abstraction in normal times. The unemployment of the Great Depression certainly revealed this to be a weakness of the Classical Model in abnormal times. (*Many years later, the energy crises of the 1970’s exposed the weakness of a Keynesian analysis with little emphasis on aggregate supply.)

We present two versions of the Classical Model. Both explore the properties of an economy where unemployment is assumed not to be an important economic issue.

7.3.1 A Simple Classical ModelThe Simple Classical Model is formulated in the spirit of the Simple Keynesian Model in that it illustrates a central point in the simplest possible framework. In terms of the three points listed above, the simplification is an assumption that labour supply is fixed rather than a function of the wage rate.

The production function and the demand for labour are explained below:

The production functionIn the classical production function, output Y is taken to be a function of capital K and labour N. (The notation for labour suggests the number of hours or the number of workers.) In the short run the capital stock is taken to be fixed at K so that

Y = f ( , N).

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Demand for labourThe marginal product of labour is dY/dN = MPN, which should be a decreasing function of Y. A profit-maximising firm should hire additional workers if P·MPN ≥ W. At the margin P·MPN = W or, equivalently, MPN = W/P. The MPN curve thus is the demand for labour.

Y

C

A

Good Year

Bad Year

Y = f (K ̅, N)

B

N

W/P NS

C

A

B

N

MPN = Nd

Fig. 7.1 The simple classical model(Source: http://www.econmacro.com/classical/simple_classical_model.htm)

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7.3.2 The Classical ModelIn the classical model, the supply of labour is an upward sloping, but not vertical function of the real wage rate. The production function and the demand for labour are explained below:

The production functionIn the classical production function, output Y is taken to be a function of capital K and labour N. (The notation for labour suggests the number of hours or the number of workers.) In the short run the capital stock is taken to be fixed at K so that

Y = f ( , N).Demand for labourThe marginal product of labour is dY/dN = MPN, which should be a decreasing function of Y. A profit-maximising firm should hire additional workers if P·MPN > W. At the margin P·MPN = W or, equivalently, MPN = W/P. The MPN curve thus is the demand for labour.

R

B A

S

D

LF

Y A

B

N

Y = f (K ̅, N)

P

B

AD AS

A

YNMPN = Nd

AB

W/P NS

Fig. 7.2 The classical model(Source: http://www.econmacro.com/classical/classical_model.htm)

The Supply of labourThe supply of labour is an increasing function of the real wage rate.

Equilibrium outputEquilibrium in the supply and demand for labour as functions of the real wage rate determines the real wage rate and the quantity of labour hired N. The quantity of labour hired then determines, via the production function, the level of output Y.

The figure shows the effects of a negative technology shock. Output goes down for two reasons. First, the labour demand curve shifts to the left, lowering the equilibrium amount of labour hired. Second, output for that amount of labour is lower because the production function has shifted downward.

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Aggregate supply and demandEquilibrium in aggregate supply and aggregate demand determines the price level P.

Aggregate supplyGiven that the level of output Y is already determined, the aggregate supply curve is vertical.

Aggregate demandThe classical aggregate demand is based on M = k P Y, where k is a constant because the velocity of money is fixed.

Supply and demand for loanable fundsAdding a supply and demand for loanable funds produces an equilibrium interest rate. This completes the Classical Model.

7.4 Keynesian Models - The Role of Aggregate DemandJohn Maynard Keynes was a very pragmatic economist writing in the context of the Great Depression. Many theories have been advanced in his name. Whether he would support any or all of them remains an open issue.

Here, the distinguishing feature of a Keynesian model is taken to be an emphasis on aggregate demand shocks as the cause of business cycles.

7.4.1 The Simple Keynesian ModelThe Simple Keynesian Model is undoubtedly too simple to be realistic. Compared to the Classical Model, it makes one truly revolutionary point: There can be equilibrium at less than full employment. A secondary point is that aggregate demand shocks (in the form of changes in investment and government spending) can have large effects on output.

The present development of the Simple Keynesian Model adds a derivation of an IS Curve. Making investment an explicit function of the interest rate within the framework of the Simple Keynesian Model shows that there is a relation between the interest rate and the level of output. That relation is a version of the IS Curve that is the element common to all the Keynesian models.

7.4.2TheIS/LMModelThis version of the IS/LM Model is central to the discussion of Keynesian models. The IS Curve is derived from equilibrium in the supply and demand for loanable funds. The LM Curve is derived from equilibrium in the supply and demand for money.

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IS/LM

LM IS

15.0

00.

00

0.00 1000.00Income

Inte

rest

rate

2

Fig.7.3TheIS/LMdiagram(Source: http://www.econmacro.com/keynesian/islm_model.htm)

Keynes’ General Theory was published in 1936, in the middle of the Great Depression. Given the extent of unemployed capital and labour, concern about a shortage of aggregate supply was not a major concern. Subsequent refinements of the notion of a Keynesian model have incorporated aggregate supply.

The IS CurveSeveral Keynesian models incorporate an IS Curve. The expanded discussion covers all these cases.

The LM CurveThe LM Curve shows those points that are consistent with equilibrium in the supply and demand for money. The LM Curve is upward sloping. An increase in income Y, given a constant money supply, must be accompanied by an increase in R to keep money demand constant.

7.4.3TheIS/MPModelThe simple version of the IS/MP Model presented here illustrates an important point. The simplified IS/MP Model adds a horizontal MP curve that depicts the interest rate set by the central bank regardless of the level of income Y. The intersection with the IS Curve then determines equilibrium output.

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IS/MPIS MP

5.00

0.00

0.00 1000.00Income

Rea

l Int

eres

t Rat

e

2

Fig.7.4TheIS/MPdiagram(Source: http://www.econmacro.com/keynesian/simple_ismp.htm)

The complete IS/MP Model is a modern reconstruction of the IS/LM Model. The main changes are putting the real interest rate (instead of the nominal interest rate) on the vertical axis of the IS/MP diagram and putting the rate of inflation (instead of the price level) on the AD/IA diagram. These changes allow for a focus on monetary policies where the central bank adjusts the interest rate in reaction to inflation.

The IS CurveSeveral Keynesian models incorporate an IS Curve. The expanded discussion covers all these cases.

The MP CurveThe MP Curve shows how the central bank sets the interest rate in reaction to the level of income Y. The idea is that the central bank leans against the wind, raising r when Y is high and lowering r when Y is low.

The simplest case is a horizontal MP Curve. In this case, the central bank simply sets the interest rate. The IS Curve then determines the level of Y.

The diagram lists the real interest rate rather than the nominal interest rate on the vertical axis. The distinction does not matter if prices are taken to be fixed. The discussion of the more general version of the IS/MP Model includes a more complete analysis of the model’s properties, and the real interest rate is appropriate for that case.

AnalysisThe effect of a monetary policy that changes the interest rate is fairly obvious. As the MP curve, which is horizontal, goes up and down, income changes according to the slope of the IS Curve. Fiscal policy, on the other hand, shifts the IS Curve.

The models presented here are all “modern” interpretations of prior writings. They benefit from decades of advances in graphical presentation and mathematical analysis.

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SummaryMacroeconomics is not an exact science such as physics. No one knows exactly how the macroeconomic variables • are related. Instead, there exist a number of models that try to explain various observations and relationships between macroeconomic variables.The foundation for the Classical Model is three basic ideas: Output is produced by capital and labour, Capital • is fixed in the short run, and Supply and demand for labour determines the amount of labour hired.The Simple Classical Model is formulated in the spirit of the Simple Keynesian Model in that it illustrates a • central point in the simplest possible framework. In terms of the three points listed above, the simplification is an assumption that labour supply is fixed rather than a function of the wage rate.John Maynard Keynes was a very pragmatic economist writing in the context of the Great Depression. Many • theories have been advanced in his name. Whether he would support any or all of them remains an open issue. The distinguishing feature of a Keynesian model is taken to be an emphasis on aggregate demand shocks as the cause of business cycles.

ReferencesParke, W.R., 2006. • Macroeconomics models and issues. [Online]Available at: <http://www.econmacro.com/index.htm> [Accessed 27 August 2012].Rittenberg, L. & Tregarthen, T., • Principles of Macroeconomics, v. 1.1. [Online] Available at: <http://catalog.flatworldknowledge.com/bookhub/reader/2728?e=rittenmacro-ch17> [Accessed 27 August 2012].Jochumzen, P., 2010. • Essentials of Macroeconomics. Book Boon.Agarwal, V., • Macroeconomics: Theory and Policy. Pearson Education India.Strickland, R., • Macroeconomics - The Keynesian Model I.mp4, [Video Online] Available at: <http://www.youtube.com/watch?v=7ObnvX64QWc> [Accessed 27 August 2012].20. econ simple Keynesian model• , [Video Online] Available at: <http://www.youtube.com/watch?v=8SFefugESXM> [Accessed 27 August 2012].

Recommended ReadingDr. Mithani, D. M., 2008. • Managerial Economics (Theory and Application), Himalaya Publishing House Pvt. Ltd.Paul, A. S., 2002. • Economics, Massachusetts Institute of Technology, Tata McGraw-Hill Publishing Company.Gupta, S. B., 2009. • Monetary Economics, Money and Payment System, S. Chand & Company, New Delhi.

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Self AssessmentWhich model is a combination or a synthesis of two models, namely the classical model and the Keynesian 1. model?

Simple classical modela. Neo-classical synthesisb. IS/LM modelc. IS/MP modeld.

The foundation for the Classical Model is ________basic ideas.2. threea. fourb. twoc. fived.

The unemployment of the ___________certainly revealed this to be a weakness of the Classical Model in 3. abnormal times.

Royal economya. No depressionb. Great Depressionc. High economyd.

Which model is formulated in the spirit of the Simple Keynesian Model in that it illustrates a central point in 4. the simplest possible framework?

Keynesian modela. Neo Classical modelb. Depression modelc. Simple Classical modeld.

In the simple classical model, demand for labour; the marginal product of labour is dY/dN = MPN, which should 5. be a ____________function of Y.

increasinga. decreasingb. equalisingc. demandingd.

___________was a very pragmatic economist writing in the context of the Great Depression6. John Maynard Keynesa. David Ricardob. Adam Smith, c. Jean-Baptiste Sayd.

Which of the following statements is true? 7. Simple Depression Model shows that there is a relation between the interest rate and the level of outputa. Simple Keynesian Model shows that there is no relation between the interest rate and the level of outputb. Simple Keynesian Model shows that there is a relation between the interest rate and the level of outputc. Simple Keynesian Model shows that there is a relation between the interest rate and the level of input.d.

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In the Classical Model, the supply of labour is an___________, but not vertical function of the real wage 8. rate.

not slopinga. downward slopingb. parallelc. upward slopingd.

The distinguishing feature of a _______________is taken to be an emphasis on aggregate demand shocks as 9. the cause of business cycles.

Simple modela. Keynesian modelb. Classical modelc. Depression modeld.

The ________is derived from equilibrium in the supply and demand for loanable funds.10. IS Curvea. LM Curveb. MP Curvec. PK Curved.

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Chapter VIII

Open Economy Macroeconomics

Aim


explicate what is open economy•

elucidate the importance of open economy macroeconomics •

explain the effect of open economy on aggregate demand and supply•

Objectives


elucidate Keynes view of open economy•

explain short run open economy macroeconomic model•

enlist short run policy goals in open economy•

Learning outcome


enlist steps to follow when evaluating the impact of fiscal and monetary policies •

understand the Kaleckian macro models for open economies•

identify IS and LM curve shift conditions•

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8.1 IntroductionA closed economy is one that does not interact with other economies in the world. There are no exports, no imports, and no capital flows.

Today all economies are open and deal in transactions with the rest of the world. A fundamental proposition of the open economy macroeconomics is that viability of a fixed exchange rate regime requires maintaining long-run consistency between monetary, fiscal and exchange rate policies. Excessive domestic credit growth leads to a gradual loss of foreign reserves and ultimately to an abandonment of the fixed exchange rate.

Keynes’ (1936) General Theory of Employment Interest and Money is developed primarily in a closed economy context. Keynes did, however, introduce an open economy analysis when he noted that:

trade could modify the magnitude of the domestic employment multiplier; • reductions in money wages would worsen the terms of trade and therefore reduce real income, while it could • improve the balance of trade; and stimulating either domestic investment or foreign investment can increase domestic employment growth•

In a world where governments are afraid that to deliberately stimulate any domestic spending will unleash inflationary forces, export-led growth is seen as a desirable alternative path for expanding domestic employment. A ‘favourable balance [of trade], provided it is not too large, will prove extremely stimulating’ to domestic employment, even if it does so at the expense of employment opportunities abroad.

8.2 The Complete Short run Open economy Macroeconomic model8.2.1 The aggregate goods market – The simple Keynesian Model.

NOTE:Aggregate demand increases when C, I• d, G, or X increases or M decreases.C is positively related to income (Y).• I• d is inversely related to the interest rate (i).X• GS are positively related to foreign real income (Yf) and positively related to the real exchange rate ( Pf x r$

per SF1/P)M• GS are positively related to Y and inversely related to the real exchange rate.

A

45o

AD

Y1 Y

AD = C + Id (i) +G (XGS – MGS)

Fig. 8.1 Aggregate goods market(Source: webpages.shepherd.edu/.../OPENECONOMYMODEL.doc)

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The aggregate goods market can be summarised with the IS curve, which shows all the combinations of the interest rate (i) and real output/income (Y) for which the goods market is in equilibrium.

The IS curve shifts when:Factors other than ∆Y change consumption (C)• Factors other than ∆i change domestic investment (I• d)∆G (Fiscal Policy)• ∆X• GS

Factors other than ∆Y change imports of goods and services (M• GS)

The IS curve DOES NOT shift when i or Y changes.

i

YIS (Equilibrium: Y = C + Id +G XGS – MGS)

Fig. 8.2 IS Curve(Source: webpages.shepherd.edu/.../OPENECONOMYMODEL.doc)

8.2.2 The Aggregate Money Market The money market is in EQUILIBRIUM at the interest rate where the quantity of money demanded = the quantity of money supplied; Md = Ms. This is demonstrated in the following diagram.

i

A

Ms

Md

Md, Ms

ii1

Quantity of money supplied

Quantity of money demanded

Fig. 8.3 Aggregate money market(Source: webpages.shepherd.edu/.../OPENECONOMYMODEL.doc)

NOTE:The quantity of money demanded is the amount of money people are willing to hold. It is positively related to • income (Y) and inversely related to the interest rate (i).The quantity of money supplied refers to certain financial assets “in circulation to the general public” (i.e. owned • by or held by people and institutions other than banks and the government).The money supply is assumed to be the sum of domestic currency held by the public and deposits at commercial • banks. The size of the money supply (Ms) is determined by the Central Bank’s monetary policy. The Central Bank can change the money supply by buying and selling domestic government bonds (GB) or foreign exchange reserves (FXR). The equation below summarises this:

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The equation says that when the Central Bank buys government bonds or foreign exchange reserves, the domestic money supply increases by a multiple of the amount of bonds or foreign exchange reserves purchased. When the Central Bank sells government bonds or foreign exchange reserves, the domestic money supply falls.

The money market can be summarised by the LM curve, which shows all the combinations of the interest rate (i) and real output/income (Y) for which the money market is in equilibrium.

LM (Equilibrium: Md = Ms)

i

Y

Fig. 8.4 LM Curve(Source: webpages.shepherd.edu/.../OPENECONOMYMODEL.doc)

The LM curve shifts when:Factors other than ∆Y or ∆i change M• d.The money supply (M• s) changes (Monetary Policy).

The LM curve DOES NOT shift when i or Y changes.

8.2.3TheForeignExchangeMarket,WhichislinkedTotheBalanceofPaymentsAccountThe foreign exchange market is linked to the balance of payments account because of its relationship to the overall balance (B), the sum of the current account and financial account.

B = CAB + FAB

=

If THE OVERALL US BALANCE = 0, the current foreign exchange rate between the US dollar and foreign currencies (say, the Swiss franc) is at the equilibrium level (e1 or $.80 per SF in the diagram below).

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e ($ per SF1) SSF

# SF

DSF

e1 = $.80 per SF1

e2

e3

US B > 0 EXCESS SUPPLY OF SF

US B > 0 EXCESS DEMAND FOR SF

OVERALL US BALANCE = CAB + FAB = 0

Fig. 8.5 Overall b alance(Source: webpages.shepherd.edu/.../OPENECONOMYMODEL.doc)

The overall balance changes when there is a change in either the CAB or the FAB, ceteris paribus.

In turn, the CAB will change when exports or imports of goods and services change. According to the open-economy Keynesian Model, these will change when domestic income (Y), foreign income (Yf), or the real exchange rate (RER) changes, where:

Specifically, an increase in Yf increases XGS. An increase in RER due to an increase in Pf or a decrease in P makes foreign products relatively expensive and therefore also increases XGS

. In turn, the increase in exports will require that people sell more foreign currency (SF) for domestic currency ($), Thus, the supply of SF increases (and the supply curve shifts right) when there is an increase in XGS due to an increase in Yf, an increase in Pf, or a decrease in P. An increase in Y increases MGS. A decrease in RER due to a decrease in Pf or an increase in P makes foreign goods relatively cheaper and therefore also increases MGS. Further, any increase in imports will necessitate an increase in the demand for foreign currency (SF). Thus, an increase in MGS due to an increase in Y, decrease in Pf, or increase in P will shift the demand curve for SF to the right.

The FAB will change when there is a change in international investors’ desire for domestic assets relative to foreign assets. In turn, this will happen in the short-run if domestic interest rates (i), foreign interest rates (if), or the expected nominal exchange rate change (eex), as suggested by the process of uncovered interest arbitrage. For example, an increase in domestic interest rates (i) will make domestic assets relatively attractive, increasing the nation’s exports of assets (pvt. XA) and reducing its imports of assets (pvt. MA). In turn, this will change the demand for and supply of foreign currency (SF), shifting both curves.

If the OVERALL US BALANCE is not “balanced” (i.e. the OVERALL BALANCE ≠ 0) and therefore there is either excess demand for or supply of foreign currency (see diagram on previous page), either the nominal exchange rate will move or the government must intervene to keep the exchange rate at the current level.

The effect of government stabilisation policies (Fiscal and monetary policies) on the macro economy in the short run

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Short-run policy goals in the open economy:Following are the policy goals in the open economy

Internal balance• : Goals related to the performance of the domestic economy in the short-run, i.e. full-employment and stable prices. In the IS-LM model this means increasing (rather than decreasing) production.External balance• : Goals related to the nation’s economic interaction with the rest of the world, i.e. the nation desires a “sustainable” balance of payments. This is usually defined as achieving a zero balance in the overall balance or, equivalently, equilibrium in the foreign exchange market.

Fiscal policy (∆G, ∆T) and monetary policy (∆Ms which changes interest rates) can achieve either of these goals. However, politicians tend to prefer fiscal and monetary policies that achieve internal balance, i.e. increase national production and employment. Thus, they have a fondness for expansionary fiscal and monetary policies: tax cuts, increases in government programs and spending, and “loose” monetary policy that keep interest rates low. However, in the open economy, the requirements for achieving external balance can prevent expansionary fiscal and monetary policies from increasing production. Whether expansionary fiscal and monetary policies increase production or not depends on

The degree of international capital mobility and on • The type of exchange rate regime the nation has.•

Degree of Mobility of Financial Capital across BordersWe will assume that financial capital is perfectly mobile across national borders, i.e. that each nation does not restrict the extent to which financial capital can move into and out of the country. In this type of environment, even miniscule changes in domestic interest rates relative to foreign interest rates can produce large and almost immediate changes in financial flows between countries. As a result, domestic and foreign interest rates will tend to equalise (when adjusted for risk).

Type of Exchange Rate RegimeIf the exchange rate is floating, maintaining external balance requires that the nominal exchange rate automatically move in response to imbalances.

e ($ per SF1)

SF dep/$ appe2

e3

SF app/$ dep

APPRECIATES/$ DEPRECIATES

US B > 0 EXCESS SUPPLY OF SF

US B > 0 EXCESS DEMAND FOR SF e INCREASES: SF

e DECREASES: SF DEPRECIATES/$ APPRECIATES

SSF

# SF

DSF

#SF

Fig. 8.6 Types of exchange rate regime(Source: webpages.shepherd.edu/.../OPENECONOMYMODEL.doc)

If overall balance > 0 (a surplus), the resulting excess supply of foreign currency will cause the domestic currency ($) to appreciate. A deficit in the overall balance will result in a depreciation of the domestic currency. Thus, if expansionary fiscal or monetary policy alters the nominal exchange rate, exports and imports of goods and services

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and thus aggregate demand can change. The change in aggregate demand due to changes in the exchange rate may offset the effect on aggregate demand of the fiscal or monetary policy.

When the exchange rate is fixed, the Central Bank must respond to imbalances in the overall balance and therefore excess demand for or excess supply of foreign currency by buying or selling foreign currency from its official foreign exchange reserves to maintain the currency’s value and thus external balance. This in turn changes the domestic money supply:

#SF

e ($ per SF1)

FXR (SF)

Sells FXR (SF)

e2

e3

e1

US B > 0 EXCESS SUPPLY OF SF CB BUYS OFF

DECREASE MS ($)

INCREASE MS ($)

US B > 0 EXCESS DEMAND FOR SF CB

DSF

Fig. 8.7 Fixed exchange rate(Source: webpages.shepherd.edu/.../OPENECONOMYMODEL.doc)

For example, if the exchange rate is fixed at e3 in the diagram above, a deficit in the overall balance and corresponding excess demand for foreign currency, will require the Central Bank to sell some of its foreign exchange reserves (SF), reducing its holdings of reserves and thus reducing the domestic money supply ($). Similarly, if the exchange rate is fixed at e2, the Central Bank will have to buy foreign currency (SF) which will increase the nominal domestic money supply ($). Thus, if an expansionary fiscal or monetary policy produces an imbalance in the overall balance, the domestic money supply may have to change to restore external balance if the nation operates under a fixed exchange rate regime. The resulting change in aggregate demand due to the money supply change may offset the impact of the fiscal or monetary policy on aggregate demand.

Steps to follow when evaluating the impact of fiscal and monetary policies in the short run in the open economy:Start with • IS-LM diagram to see what impact the policy potentially has on domestic output/income in the short-run.Since the link between the domestic economy and the international economy is the domestic interest rate relative • to the foreign interest rate, note the change in the domestic interest rate.Determine • the impact of the policy on external balance: explain what impact the change in domestic interest rate relative to the foreign interest rate will have on the FAB and therefore on the overall balance.Determine whether the change in the overall balance produces an excess demand for or supply of foreign • currency, using the foreign exchange market diagram.

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To restore external balance, indicate the required change in the money supply (fixed exchange rate regime), or • the required change in the nominal exchange rate (flexible exchange rate regime).Analyze the impact of the restoration of external balance (step 5) on domestic output/income using the • IS-LM diagram.

8.3 Kaleckian macro models for open economiesMichal Kalecki (1899-1970) has long been recognised as one of the main progenitors of what has come to be known as the ‘Post Keynesian’ approach in economics. Kalecki’s contributions to international economics Kalecki’s contributions to international economics arise in three main parts of his work: his analysis of the role of net exports in the determination of the level of profits and national income; his analysis of the financing of investment in developing countries; and his analysis of causes of changes in profit mark-ups.

Kalecki believed that the positive relationship between trade surpluses and profit realisation was the root cause of international conflicts over market shares, as reflected in the economic imperialism of the early twentieth century. Today, conflicts over trade imbalances persist between deficit countries such as the United States and the United Kingdom on the one side and surplus countries such as Germany and Japan on the other. A two-country version of a neo-Kaleckian macro model can be seen as a Kaleckian version of the standard Keynesian two-country model with ‘repercussion effects.’ The standard model is usually applied to analyze the effects of fiscal and monetary policies under alternative assumptions about such factors as the degree of capital mobility and the exchange rate regime. Here, we emphasise instead the effects of changes in the relative competitiveness of national economies (as reflected in their unit labour costs, that is, wages adjusted for productivity). We also take the wage– profit distribution of income into account and emphasise the results for profits rather than national income in each country.

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SummaryToday all economies are open and deal in transactions with the rest of the world. A fundamental proposition • of the open economy macroeconomics is that viability of a fixed exchange rate regime requires maintaining long-run consistency between monetary, fiscal and exchange rate policies.Keynes introduced an open economy analysis when he noted that: trade could modify the magnitude of the • domestic employment multiplier; reductions in money wages would worsen the terms of trade and therefore reduce real income, while it could improve the balance of trade; and stimulating either domestic investment or foreign investment can increase domestic employment growth. The money market can be summarised by the LM curve, which shows all the combinations of the interest rate • (i) and real output/income (Y) for which the money market is in equilibrium.Michal Kalecki (1899-1970) has long been recognised as one of the main progenitors of what has come to • be known as the ‘Post Keynesian’ approach in economics. Kalecki’s contributions to international economics Kalecki’s contributions to international economics arise in three main parts of his work: his analysis of the role of net exports in the determination of the level of profits and national income; his analysis of the financing of investment in developing countries; and his analysis of causes of changes in profit mark-ups.

ReferencesDeprez, J. & Harvey, J. T., 1998. • Foundations of International Economics: Post-Keynesian Perspectives, USA: Routledge.Asbjorn, R., 2000. • Open Economy Macroeconomics. Cambridge University PressMart´ın Uribe. 2007. • Lectures in Open Economy Macroeconomics. [pdf] Available at: < http://public.econ.duke.edu/~uribe/econ366/lecture_notes.pdf> [Accessed 28 August 2012].Open Economy Macroeconomics• . [Online] Available at: < http://www.angelfire.com/id/SergioDaSilva/open.html> [Accessed 28 August 2012].Dr. Dastidar, A. G., 2012. • Open Economy Macroeconomics, Interest Rate Parity.4, [Video Online] Available at: <http://www.youtube.com/watch?v=goa_PnqWOs4> [Accessed 28 August 2012].Dr. Dastidar, A. G., 2012. • Open Economy Macroeconomics, Interest Rate Parity.2-4,[Video Online] Available at: < http://www.youtube.com/watch?v=fwsweVGCmwo> [Accessed 28 August 2012].

Recommended ReadingMd. Hossain, A. & Chowdhury, A., 1998. • Open-Economy Macroeconomics for Developing Countries. Elgar Pub.Rivera-Batiz, F. L. & Rivera-Batiz, L., 1994. • International finance and open economymacroeconomics. Macmillan.Maurice, O. & Kenneth, R., 1996. • Foundations of International Macroeconomics. The MIT Press.

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Self AssessmentWhich does not interact with other economies in the world?1.

Open economya. Closed economyb. Fixed economyc. Fluctuating economyd.

Which of the following statements is true?2. Excessive domestic credit growth leads to a gradual profit of foreign reserves and ultimately to an a. abandonment of the fixed exchange rate.Excessive domestic credit growth leads to a gradual loss of foreign reserves and ultimately to an increase b. in the fixed exchange rate.Excessive domestic credit growth leads to a gradual loss of foreign reserves and ultimately to an abandonment c. of the fixed exchange rate.No domestic credit growth leads to a gradual loss of foreign reserves and ultimately to an abandonment of d. the fixed exchange rate.

__________________is developed primarily in a closed economy context.3. General Theory of Employment Interest and Moneya. Permanent income hypothesisb. Quantity theory of moneyc. Rational choice theoryd.

Keynes noted that ________could modify the magnitude of the domestic employment multiplier.4. peoplea. employmentb. industryc. traded.

Keynes noted that reductions in __________would worsen the terms of trade and therefore reduce real income, 5. while it could improve the balance of trade.

money wagesa. trade b. investmentc. employmentd.

Keynes noted that stimulating either domestic investment or foreign investment can increase domestic _______ 6. growth.

investmenta. employmentb. tradec. industryd.

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The __________ does not shift when i or Y changes.7. LP curvea. AD curveb. IS curvec. MP curved.

Whether expansionary fiscal and monetary policies increase production or not depends on the degree of 8. _____________.

international debt policya. national loan analysisb. international capital mobilityc. international revenue policyd.

Who has been recognised as one of the main progenitors of the ‘Post Keynesian’ approach in economics?9. Michal Kaleckia. Paul Samuelsonb. Max Weberc. Georg Simmeld.

Kalecki believed that the positive relationship between _____________ and profit realisation was the root cause 10. of international conflicts over market shares.

monetary policiesa. trade surplusesb. industrial agreementsc. market demandd.

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Case Study I

Great Depression of 1929

The Great Depression of 1929 was a worldwide depression that lasted for 10 years. It was a “Black Thursday”, October 24, 1929, when 12.9 million shares of stock were sold in one day which were triple of the original amount. There was a stock market crash, as share prices fell down by 15-20%.

Unemployment Till the year 1933, the height of depression and unemployment rate was raised from 3% to 25 % of the total nation’s workforce. Wages were also lowered. Gross Domestic Product (GDP) was cut in half from $103 to $55 billion. This was partly because of deflation as prices fell down by 10 % every year.

The depression had adverse effects on the agriculture land. Hence, many farmers lost their farms. At the same time, the long time erosion and drought created a situation in some places where no crops were grown. Many farmers and other unemployed people travelled to California to find jobs. Most of the people were left homeless. Thus, the unemployment was raised to a greater extent.

Causes of Great DepressionAccording to Ben Bernake, the Chairman of the Federal Reserve, the main reason behind the stock market crash and consequent depression was the tight monetary policies that the Federal Reserves established at that time.

Bernake highlighted several Federal mistakes which caused the depression:The Federal Reserves did not increase the supply of money to fight against the depression.• They raised the interest rates to preserve the value of dollar. This further caused unavailability of money for • businesses, leading to bankruptcies. The Federal had raised the funds rate and kept on increasing throughout the recession that began in August • 1929. This was the root cause for stock market crash.As investors withdrew all their dollars from banks, the banks failed and there was more fear. The people had • no confidence with the banks. Most of the people withdrew their cash and just accumulated with them, which further decreased the money supply.

(Source: Great Depression of 1929, [Online] Available at: <http://www.personal.psu.edu/dbh5017/art002/a7/Causes.html> [Accessed 7 August 2012])

QuestionsWhy the unemployment rate increased in USA during 1929?1. AnswerThe unemployment rate was raised from 3% to 25 % of the total nation’s workforce. Wages were also lowered. GDP was cut in half from $103 to $55 billion. This was partly because of deflation as prices fell down by 10 % every year. The depression had adverse effects on the agriculture land. Hence, many farmers lost their farms. At the same time, the long time erosion and drought created a situation in some places where no crops were grown. Many farmers and other unemployed people travelled to California to find jobs. Most of the people were left homeless. Thus, the situation of unemployment was raised to a greater extent.

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What was the main cause of depression in USA?2. Answer:The main cause of great depression in USA was the tight monetary policies established by the Federal Reserves at that time.

How was the Federal Reserve responsible for depression and stock market crash?3. AnswerThe Federal Reserves had committed following mistakes that lead to great depression and stock market crash:

The Federal Reserves did not increase the supply of money to fight against the depression. �They raised the interest rates to preserve the value of dollar. This further caused unavailability of money �for businesses, leading to bankruptcies. The Federal had raised the funds rate and kept on increasing throughout the recession. This was the root �cause for stock market crash.As investors withdrew all their dollars from banks, the banks failed, which resulted in more panic. The �people had no confidence with the banks. Many people withdrew their cash and just accumulated with them, which further decreased the money supply.

Explain how the monetary policy affects the economy of a nation?4. AnswerMonetary Policy affects the rate of interest. It is the way in which the government controls the economy. If money supply goes too fast then the inflation rises and if it goes too slow then the nation's output lessens, that means the GDP also decreases. So the money supply must be controlled so that it would not change the economic level of a nation.

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Case Study II

Japanese Business Cycle (1945 - till now)

After the World War II, Japan was totally devastated in the bombings of Hiroshima and Nagasaki. There was scarcity of all the necessary goods. As a result, the price of the products were significantly increased which lead to high inflation. There were no jobs, and people could not afford the high priced commodities. That is why; there was no flow of money in the market. Due to this situation, there was along-lasting recession in the economy.

From the 1960s to the 1980s, Japan’s overall real economic growth has been considered as a miracle - a 10% average in the 1960s, a 5% average in the 1970s and a 4% average in the 1980s

Growth was considerably slowed down in the late 1990s. This period was called "the Lost Decade." The bank of Japan failed to cut interest rates quickly enough to counter after effects of over-investment during the late 1980s. Some economists believe that because the Bank of Japan failed to cut rates, Japan entered a liquidity trap. Therefore, to increase economic growth, Japan ran massive budget deficits (added trillions in Yen to Japanese financial system) to finance large public works programs.

By 1998, Japan's public works projects still could not stimulate enough demand to end the economy's stagnation. In extreme anxiety, the Japanese government undertook "structural reform" policies planned to twist tentative excesses from the stock and real estate markets. Unfortunately, these policies led Japan into deflation at numerous times between 1999 and 2004.

By late 2005, the economy was able to recover slowly. GDP growth for that year was 2.8%, with an annualized fourth quarter expansion of 5.5%, exceeding the growth rates of the US and European Union during the same period. Thus, the domestic consumption has been the dominant factor for the growth of economy.

Eventually, a carry trade developed in which money was borrowed from Japan, invested for returns elsewhere and then the Japanese were paid back, with a nice profit for the trader. The improvements to bankruptcy law, land transfer law, and tax laws increased the economic growth. In recent years, Japan has been the top export market for almost 15 trading nations worldwide.

(Source: Japanese Business Cycle (1945-till now), [Online] Available at: <http://www.dailykos.com/story/2009/02/11/695967/-Debunking-Republican-Spin-Japan-in-the-90s> [Accessed 27 August 2012]).

QuestionsWhy did Japan face deflation from 1999 to 2004?1. How Japan increased its rate of economic growth?2. Which was the dominant factor for the growth of economy in Japan in 2005?3. How is the GDP calculated?4.

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Case Study III

TheIndianEconomyDealingwithInflationin2006-07

In the early 2007 and the end of 2006, the inflation rate in India was around 6-6.8%. Previously, the main cause of high inflation in India was the rise in global oil prices. However, in early 2007, the main reason for the inflation was the increase in the prices of food articles which was caused by increased demand as well as supply constraints. According to analysts, the increased demand was because of high economic growth and increased money supply, while the stagnant agricultural productivity caused supply constraints.

CausesofInflationGenerally,thetwomainreasonsbehindinflationare:

rise in demand or demand pull inflation• rise in cost of factor production or cost push inflation.•

The average annual GDP growth in the 2000s was about 6% and during the second quarter (July-September) of fiscal 2006-2007, the growth rate was as high as 9.2%. This was definitely going to increase the demand for goods. However, the growth in the supply of goods, especially food articles such as wheat and pulses, was not increasing directly with the growth in demand. As a result, the prices of food articles increased considerably.Measures Taken to Control Inflation

In late 2006 and early 2007, the RBI announced some measures to control inflation. These measures were as follows:

increase the repo rates• increase the Cash Reserve Ratio (CRR) • reduce the rate of interest on cash deposited by banks with the RBI. •

With the increase in the repo rates and bank rates, banks had to pay a higher interest rate for the money they borrowed from the RBI. Consequently, the banks increased the rate at which they lent to their customers. The increase in the CRR reduced the money supply in the system because banks now had to keep more money as reserve.

(Source: TheIndianEconomyDealingwithInflationin2006-07, [Online] Available at: <http://www.scribd.com/doc/25490961/inflation-case-study> [Accessed 27 August 2012]).

QuestionsWhat were the causes of inflation?1. In India, why the inflation rate increased in 2006-07?2. How inflation rate can be controlled?3. What happens when banks increases the repo rates and bank rates to control inflation?4.

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Bibliography

References20. econ simple Keynesian model, [Video Online] Available at: <http://www.youtube.com/watch?v=8SFefugESXM> • [Accessed 27 August 2012].Agarwal, V., • Macroeconomics: Theory and Policy. Pearson Education India.Aggregate Demand (AD) Curve,• [Online]. Available at: <http://www.cliffsnotes.com/study_guide/Aggregate-Demand-AD-Curve.topicArticleId-9789,articleId-9737.html> [Accessed 20 August 2012].Aggregate Demand (AD) Curve,• [Online]. Available at: <http://www.cliffsnotes.com/study_guide/Aggregate-Demand-AD-Curve.topicArticleId-9789,articleId-9737.html> [Accessed 20 August 2012].Aggregate Supply and Aggregate Demand• , [Video Online] Available at: <http://www.youtube.com/watch?v=KX5XOxHAFpE> [Accessed 20 August 2012].Aggregate Supply and Aggregate Demand• , [Video Online] Available at: <http://www.youtube.com/watch?v=KX5XOxHAFpE> [Accessed 20 August 2012].Arestis, P., 2005. • The New Monetary Policy: Implications And Relevance. Edward Elgar PublishingAsbjorn, R., 2000. • Open Economy Macroeconomics. Cambridge University PressBusiness Cycle Theory - Introduction to Austrian Economics, 7of11• .[Video Online]. Available at: <http://www.youtube.com/watch?v=Bxq_mhdYeBM> [Accessed 22August 2012]De, S., 2012• . Fiscal Policy in India: Trends and Trajector, [pdf]Available at: <http://finmin.nic.in/workingpaper/FPI_trends_Trajectory.pdf> [Accessed 24 August 2012]Deprez, J. & Harvey, J. T., 1998. • Foundations of International Economics: Post-Keynesian Perspectives, USA: Routledge.Devan, J., Rowland, M. & Woetzel, J., 2009. A • Consumer Paradigm for China. [Online]Available at: <http://mkqpreview1.qdweb.net/A_consumer_paradigm_for_China_2429> [Accessed 17 November 2010].Dornbusch, R., 2005. • Macroeconomics. Tata McGraw-Hill EducationDr. Dastidar, A. G., 2012. • Open Economy Macroeconomics, Interest Rate Parity.4, [Video Online] Available at: <http://www.youtube.com/watch?v=goa_PnqWOs4> [Accessed 28 August 2012].Dr. Dastidar, A. G., 2012. • Open Economy Macroeconomics, Interest Rate Parity.2-4, [Video Online] Available at: < http://www.youtube.com/watch?v=fwsweVGCmwo> [Accessed 28 August 2012].Economics 1 - Lecture 16: Overview of Macroeconomics• , [Video Online] Available at: <http://www.youtube.com/watch?v=DJwuQ6VLi1U> [Accessed 17 August 2012].Fiscal and Monetary Policy Overview• , [Video Online]. Available at: <http://www.youtube.com/watch?v=5gvFwDPaOQ0&feature=fvwrel> [Accessed 23 August 2012].Fiscal Policy Explained Simple Way• , [Video Online] Available at: <http://www.youtube.com/watch?v=zgH4D1H0Ti4> [Accessed 24 August 2012]Fiscal Policy, • [Online] Available at: <www.svtuition.org/2010/03/fiscal-policy.html> [Accessed 19 November 2010].Hoag, A. J. & Hoag, J. H., 2006• . Introductory Economics. World Scientific.Hubbard, R. G., 2007. • Macroeconomics. Pearson Education India.Introduction to Macroeconomics• , [Online] Available at: <http://www.scribd.com/doc/12374776/Overview-of- Macroeconomics> [Accessed 10 November 2010].Jhingan, M. L., 2009.• Managerial Economics, Money Supply. Vrinda Publications Pvt. Ltd, New Delhi.Jhingan, M. L., 2010. • Meaning and Measurement of Macroeconomics, Managerial Economics. Delhi. Vrinda Publications Pvt. Ltd.Jhingan, M. L., 2010. • Meaning and Measurement of Macroeconomics, Managerial Economics. Delhi. Vrinda Publications Pvt. Ltd.

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Jochumzen, P., 2010. • Essentials of Macroeconomics. Book Boon.Kimberly, A., 2009. • Economic Depression, [Online] Available at: <useconomy.about.com/od/grossdomesticproduct/f/Depression.htm> [Accessed 12 November 2010].Kimberly, A., 2009. • Economic Depression, [Online] Available at: <useconomy.about.com/od/grossdomesticproduct/f/Depression.htm> [Accessed 12 November 2010].Langdana, F., 2009• . Macroeconomic Policy: Demystifying Monetary and Fiscal Policy. Springer.Lipsey, R. G. & Chrystal, K A., 2007. • Economics. Oxford University PressMacro Unit 3 Intro- Aggregate Demand, Aggregate Supply, and Fiscal Policy• , [Video Online] Available at: <http://www.youtube.com/watch?v=6lnw7s9KOMM> [Accessed 20 August 2012].Macro Unit 3 Intro- Aggregate Demand, Aggregate Supply, and Fiscal Policy• , [Video Online] Available at: <http://www.youtube.com/watch?v=6lnw7s9KOMM> [Accessed 20 August 2012].Mankiw, N. G., 2008. • Brief Principles of Macroeconomics. Cengage Learning.Mankiw, N. G., 2008. • Brief Principles of Macroeconomics. Cengage Learning.Mart´ın Uribe. 2007. • Lectures in Open Economy Macroeconomics. [pdf] Available at: < http://public.econ.duke.edu/~uribe/econ366/lecture_notes.pdf> [Accessed 28 August 2012].Monetary and Fiscal Policy, • [Video Online].Available at: <http://www.youtube.com/watch?v=ntxMOKXHlfo> [Accessed 24 August 2012]Monetary Policy, • [Online] Available at: <www.finpipe.com/monpol.htm> [Accessed 18 November 2010].Open Economy Macroeconomics• . [Online] Available at: < http://www.angelfire.com/id/SergioDaSilva/open.html> [Accessed 28 August 2012].Parke, W.R., 2006. • Macroeconomics models and issues. [Online]Available at: <http://www.econmacro.com/index.htm> [Accessed 27 August 2012].Petrov, K., • Macroeconomics, Lecture 01, [Video Online] Available at: <http://www.youtube.com/watch?v=INPhEyH_gH0> [Accessed 17 August 2012]Professor Shiller, 2012. • Monetary Policy.[Video Online].Available at: <http://www.youtube.com/watch?v=_SpIaGTq0u8> [Accessed 23 August 2012].Reserve Bank of India• . [Online] Available at: <www.rbi.org.in/scripts/NotificationUser.aspx?Id=5602&Mode=0> [Accessed 18 November 2010].Rittenberg, L. & Tregarthen, T• ., Principles of Macroeconomics, v. 1.1. [Online] Available at: <http://catalog.flatworldknowledge.com/bookhub/reader/2728?e=rittenmacro-ch17>[Accessed 27 August 2012].Roubini, N., 2008. • Stern School of Business, New York University. [pdf] Available at: <msnbcmedia.msn.com/i/msnbc/sections/tvnews/nightly%20news/roubini022608.pdf.> [Accessed 17 November 2010].Shostak, F., 2010. • Unemployment is the key to US Economy. [Online] Available at: <http://mises.org/daily/4724> [Accessed 10 November 2010].Strickland, R., • Macroeconomics - The Keynesian Model I.mp4, [Video Online]. Available at: <http://www.youtube.com/watch?v=7ObnvX64QWc> [Accessed 27 August 2012].Taylor, J. B., 2001. • Monetary Policy Rules. University of Chicago Press.The Business Cycle: The business cycle and how it may be driven by emotion• , [Video Online]. Available at: <http://www.youtube.com/watch?v=TXrOpjG4dUs> [Accessed 22August 2012]

Recommended ReadingDr. Mithani, D. M., 2008. • Business Cycle, Institute of Business Study and Research, Himalaya Publishing House Pvt. Ltd.Dr. Mithani, D. M., 2008. • Managerial Economics (Theory & Application). Institute of Business Study and Research. Himalaya Publishing House Pvt. Ltd.Dr. Mithani, D. M., 2008. • Managerial Economics (Theory and Application), Himalaya Publishing House Pvt. Ltd.

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Geetika, 2008. Managerial Economics, Money Supply and Economics. Tata McGraw-Hill Publishing Co., New • Delhi.Gupta, S. B., 2009. • Monetary Economic Money and Payment System, the Demand for Money, S. Chand & Company, New Delhi.Gupta, S. B., 2009. • Monetary Economics. Money and Payment System, S. Chand & Company, New Delhi.Jhingan, M. L., 2009. • Managerial Economics, Monetary Policy. Vrinda Publications Pvt. Ltd., New Delhi.Maurice, O. & Kenneth, R., 1996. • Foundations of International Macroeconomics. The MIT Press.Md. Hossain, A. & Chowdhury, A., 1998. • Open-Economy Macroeconomics for Developing Countries. Elgar Pub.Paul, A. S., 2002. • Economics, Massachusetts Institute of Technology, Tata McGraw-Hill Publishing Company.Rivera-Batiz, F. L. & Rivera-Batiz, L., 1994. • International finance and open economymacroeconomics. Macmillan.Samuelson, P. A., 2002. • Economics, Central Banking and Monetary Policy.. Tata McGraw-Hill Publishing Company.Samuelson, P. A., 2002. • Economics, Measuring Economic Activity, Tata McGraw-Hill Publishing Company.

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Self Assessment Answers

Chapter Id1. a2. a3. c4. b5. b6. d7. a8. b9. b10.

Chapter IIa1. b2. d3. b4. b5. c6. b7. a8. b9. b10.

Chapter IIIb1. c2. a3. a4. c5. a6. a7. a8. d9. a10.

Chapter IVb1. b2. a3. a4. d5. a6. b7. c8. c9. a10.

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Chapter Va1. d2. a3. a4. d5. a6. d7. a8. d9. a10.

Chapter VIa1. a2. b3. c4. a5. a6. d7. a8. a9. a10.

Chapter VIIb1. a2. c3. d4. b5. a6. c7. d8. b9. a10.

Chapter VIIIb1. c2. a3. d4. a5. b6. c7. c8. a9. b10.

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