sudip macro epbm 16 1st part
DESCRIPTION
Macro economics 1st partTRANSCRIPT
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MacroeconomicsEPBM 16
Sudip Chaudhuri
1st Part(Topics 1 to 3)
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Topics
1. Overview of Macroeconomics
2. National Income Accounting
3. Business Cycles and Multiplier
4. Money and Monetary Policy
5. Balance of Payments and Foreign Exchange Rates
6. Open Economy Macroeconomics
7. Strategy of Economic Development
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Topic 1
Overview of Macroeconomics
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What is Macroeconomics?
• Microeconomics focuses on how decisions are made by individuals and firms and the consequences of those decisions
• Macroeconomics examines the aggregate behavior of the economy – how the actions of all individuals and firms in the economy interact to produce a particular level of economic performance as a whole.
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Great Depression
• The sharp fall in aggregate output and employment levels which started in 1929 and lasted through the 1930s
• This gave rise to modern macroeconomics– Macroeconomic theory changed dramatically
with the 1936 publication of the book, The General Theory of Employment, Interest and Money by John Maynard Keynes
– Important mission of modern macroeconomics: to prevent anything like the Great Depression from happening again
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The Great Depression
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Potential output
K : Total physical capital stock, i.e., total final investment goods installed in the economy at a point of
time
Potential output: Maximum possible production level (at constant prices) during the period
(year), given K, supply of labour, human capital, technology etc
K
Potential Output
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Goods and services produced
• Intermediate goods and services, i.e, those which are used up in the process of production, e.g., yarn for weaving cloth, iron-ore for producing steel, fertilizers for producing wheat
• Final consumption goods and services, i.e., those which are purchased by the household sector. Examples are: rice, garments, fees paid to doctors, bus fare refrigerator, TV
• Final investment goods, i.e., durable goods like plant and machinery, buildings, roads, bridge
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Demand-constrained economy(aggregate demand < potential output)
(Recession/depression)
Potential amount not producedAggregate demand
Potential outputK
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Recession/depression
• Recession:– Decline in output, income and employment
lasting more than few months • Depression:
– a recession that is large in both scale and duration
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Supply-constrained economy (aggregate demand > potential output)
(Demand-pull inflation)
Potential output
Aggregate demand
K
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Inflation
• Demand-pull inflation• Cost-push inflation• Stagflation
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Market
• Is a mechanism through which buyers and sellers interact to determine prices and exchange goods and services
• Different types of market:– Details in the next Economics course
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Competitive Market
• Is a market in which there are many buyers and sellers of the same good or service
• Three elements:– Demand curve– Supply curve– Equilibrium price
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Market Equilibrium
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Shifts in Supply or Demand Change
Equilibrium Price and Quantity
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MacroeconomicsThree central questions
• Why do output and employment sometimes fall and what can be done about it
• What are the sources of inflation and how can it be controlled
• How can a nation increase its rate of economic growth
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Why demand is deficient and how it can be increased
Aggregate demand
Potential outputK
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How demand can be managed to tackle
demand-pull inflation
Potential output
Aggregate demand
K
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How K (and productivity etc) can be increased
to accelerate growth
Potential outputK
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Measuring economic success
• Growth of output - GDP and per capita GDP/GNI
• Price stability - Inflation rate• Low unemployment (and poverty) rates• External balance:
– Trade deficit– Current account deficit (CAD)– BOP deficit
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Growth rate
• Growth rate of GDP (percent)
((GDPt – GDPt-1)/GDPt-1) x 100
• Inflation rate
((Pt – Pt-1)/Pt-1) x 100, where
–P: Annual averages of price indexes
–Or Year-on-year
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1951
-52
1955
-56
1959
-60
1963
-64
1967
-68
1971
-72
1975
-76
1979
-80
1983
-84
1987
-88
1991
-92
1995
-96
1999
-00
2003
-04
2007
-08
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
12.0
Growth Rate of Real GDP, India, 1951-2008
Year
An
nu
al g
row
th r
ate
in p
erce
nt
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1950
-51
1954
-55
1958
-59
1962
-63
1966
-67
1970
-71
1974
-75
1978
-79
1982
-83
1986
-87
1990
-91
1994
-95
1998
-99
2002
-03
2006
-07
0
5000
10000
15000
20000
25000
30000
Per Capita Real GNP, India, 1951-2008
Year
In R
up
ees
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USA
SOUTH KOREA
RUSSIA
MALAYSIA
BRAZIL
CHINA
INDIA
0 10,000 20,000 30,000 40,000 50,000
47,094
29,518
15,258
13,927
10,607
7,258
3,337
Gross National Incomeper capita, 2008, $ PPP
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Purchasing Power parity
• The PPP between two countries’ currencies is the exchange rate at
which a given basket of goods and services would cost the same amount
in each country
• Suppose a basket of goods and services that costs $ 100 in USA, costs
Rs 900 in India. Then the PPP is Rs 9 per US $
• Re-$ PPP is approx 20% of the market exchange rate
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Real GDP per capita
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1971
-72
1974
-75
1977
-78
1980
-81
1983
-84
1986
-87
1989
-90
1992
-93
1995
-96
1998
-99
2001
-02
2004
-05
2007
-08
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
30.0
Price Inflation, WPI, India, 1970-2009
Year
Rat
e o
f in
flat
ion
in
per
cen
t
In India, Wholesale Price Index more common than Consumer Price Index
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1990
-91
1992
-93
1994
-95
1996
-97
1998
-99
2000
-01
2002
-03
2004
-05
2006
-07
2008
-09
-12.0
-10.0
-8.0
-6.0
-4.0
-2.0
0.0
2.0
4.0
India's Trade and Current Account Deficit
Trade deficitCAD
Year
As
per
cen
tag
e o
f G
DP
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Rural Urban Combined
Percentage
1973 56.4 49.0 54.9
1983 45.7 40.8 44.5
1993 37.3 32.3 36.0
2004 28.3 25.7 27.5
Number (Lakhs)
1973 2612.9 600.46 3213.36
1983 2519.57 709.4 3228.97
1993 2440.31 763.37 3203.68
2004 2209.24 807.96 3017.20
Persons below Poverty line in India
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Tools of Economic Policy
• Fiscal Policy:– Government expenditure and taxes
• Monetary Policy:– Money supply, credit, interest rates
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Recommended text
• Paul Samuelson and William Nordhaus
Economics, 19th edition
Tata McGraw Hill
Indian Adaptation by
Sudip Chaudhuri and Anindya Sen,
Chapters 19 to 31
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For Examination
• PPTs uploaded• Class discussions• Economics, 19th edition:
– Chapter 19 (except pages 476 to 481)– Chapter 20– Chapter 21– Chapter 22 (except pages 557 to 559)– Chapter 23 (except pages 593 to 595; 602 to 605)– Chapter 24 (except pages 625 to 638)– Chapter 27 (except pages 720 to 724)– Chapter 28 (except pages 745 to 757)
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Some useful sources of data
• UNDP: http://hdr.undp.org/en/statistics/data/• IMF: http://
www.imf.org/external/pubs/ft/weo/2008/01/weodata/index.aspx
• World Bank: http://worldbank.org• RBI: http://
www.rbi.org.in/scripts/AnnualPublications.aspx?head=Handbook%20of%20Statistics%20on%20Indian%20Economy
• Min of Finance: http://indiabudget.nic.in/• CSO: http://mospi.gov.in/mospi_cso_rept_pubn.htm
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Topic 2
National Income Accounting
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The National Accounts
Almost all countries calculate a set of numbers known as the national income and
product accounts.
The national income and product accounts, or national accounts, keep track of the flows
of money between different parts of the economy.
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In India
Central Statistical Organization, New Delhi publishes every year the National Accounts
Statistics(http://mospi.gov.in/mospi_cso_rept_pubn.htm)
(New users can register free)
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Gross Domestic Product
• Market value of all FINAL goods and services produced within a country in a given period of time
• Note:– Included in GDP:
• Not only goods but also services• Only those with market value • Even if not sold
– Excluded in GDP:• Financial assets like stocks • Foreign produced goods & services• Used goods
• FINAL: does not mean intermediate goods & services are ignored
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Two ways of calculating GDP
• Final use (or Flow of product) method– Here we ignore the intermediate goods and services
and concentrate only on the Final goods and services which have not been used up in the process of production
– GDP is calculated by adding the value of production of all the final goods and services produced, i.e., the value of production of all the final consumption and investment goods and services.
• Income (or earnings) method– GDP is calculated by adding all the factor incomes
accruing to the household sector.
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Some definitions• Value of production is defined as (quantity of
production) x (price of the product). Thus the value of cloth produced = (quantity of cloth produced in meters) x (the price per meter)
• Profits = Sales – wages – raw materials/services costs
• Thus Sales = profits + wages + raw materials/services costs
• Value added is defined as Value of production - cost of raw materials purchased= Profits + wages
(Note: other incomes are interest and rent)
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Yarn cost
W1
R1
Cloth
Yarn
R: profits
W: wages
R2
W2
Cotton cost R3
W3
Cotton
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Problem of “double counting”
• Problem arises if we take value of production of all goods and services, i.e., both intermediate and final
• Problem tackled by taking:– VALUE OF PRODUCTION of ONLY FINAL
goods and services– or VALUE ADDED of ALL goods and services
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Thus
• GDP
= C + I + G + X (Product approach)
= Profits + wages + other incomes
+ depreciation + net production taxes (Earnings approach)
• Aggregate production generates equivalent incomes
• Note: GDP at market price = GDP at factor cost + indirect taxes – subsidies.
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WhereC: Consumption = aggregate consumption
expenditure by households on goods and services
I: Private Investment = aggregate investment expenditure by private sector= Fixed investment = expenditure on final
investment goods (durable goods like plant, machinery, buildings)
+ Net change in inventoriesG: Aggregate government expenditure on goods
and services including on investment goodsX: Net exports = Aggregate exports of goods and
services minus Aggregate imports of goods and services
NOTE: If I = total I, then G = consumption expenditure
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Why Imports are deducted
GDP = (C – Cm) +(I – Im) +(G – Gm) +(Ex – Exm), where Ex: exports
Or, GDP =C + I + G + Ex – (Cm + Im + Gm + Exm)
Or, GDP = C + I + G + Ex – M, whereM = Cm + Im + Gm + ExmOr, GDP = C + I + G + X
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Circular Flow Diagram
The Flows of money, goods and services and factors of production
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Circular Flow Diagram
• Connects the four sectors of the economy– Households– Firms– Government– and the Rest of the world
• Via three types of markets– the factor markets– the markets for goods and services– and the financial markets
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Income
Land,
Labour,
capital
Goods &
services
bought
Consumer spending
Goods &
Services sold
Factors of
production
Wages, rent, interest,
dividends
Revenue
Two-Sector Circular Flow Diagram
FIRMS
HOUSEHOLDS
Factor marketsMarket for goods
& services
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Consumer
spending
Govt exp on
goods & services
Firms
Households
Factor
marketsMarket for goods
& services
Financial
markets
Government
Rest of
World
Wages etc
Wages etc
Barrowing & stocks issued
Imports
Exports
I spending
GDP
Household savings
Government borrowing
Foreign borrowing etc
Foreign lending etc
TaxesTransfersSalaries
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Demand-constrained economy
Aggregate demand = C+I+G+X
Potential outputK
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GNP (or GNI)
• Gross national product or Gross national income is defined as the sum total of the incomes which accrue to the residents of the country
• Residents – individuals and enterprises:– Not based on nationality or legal criteria but
on– “Center of Interest” in the economy
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GNP (or GNI)
GNP =
GDP + (earnings of residents from supply of factors of production to non-residents) – (payments made by residents to non-residents for factors of production received)
Or, GNP = GDP + net factor earnings of the residents from the rest of the world
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Real GDP
GDP at constant prices to find out how aggregate production has
changed in real terms
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Example
Year 1 Year 2
Quantity of apples 2000 2200
Price of apple Rs 10 Rs 15
Quantity of oranges 1000 1200
Price of orange Rs 5 Rs 7.5
Nominal GDP Rs 25000 Rs 42000
Real GDP Rs 25000 Rs 28000
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Real GDP
• Real GDP (GDP at constant prices)– it is the total value of final goods and services
produced in the economy during a year, calculated as if prices had stayed constant at the level of some given base year (1999-2000; recently changed to 2004-05)
• Nominal GDP (GDP at current prices),– GDP number that has not been adjusted for changes
in prices is calculated using the prices in the year in which the output is produced
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1952
-53
1956
-57
1960
-61
1964
-65
1968
-69
1972
-73
1976
-77
1980
-81
1984
-85
1988
-89
1992
-93
1996
-97
2000
-01
2004
-05
0
1000000
2000000
3000000
4000000
5000000
Nominal and Real GDP, India, 1951-2008
GDP at Factor Cost at current pricesGDP at factor cost at 1999-2000 prices
Year
Rs
cro
res
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Inflation
• Process of overall price rise• Calculated on the basis of price indexes:
– WPI more common than CPI in India
• Implicit GDP deflator (ratio of Nominal GDP/Real GDP)
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Price Indexes used in India Base year
Compiled by
Wholesale Price Index (WPI) 1993-94(recently changed to 2004-05)
Office of the Economic Adviser, Ministry of Commerce and industry
Consumer Price Index for Industrial Workers (CPI-IW)
2001 Labour Bureau, Ministry of Labour and Employment
Consumer Price Index for Agricultural Labour (CPI-AL
1986-87 Labour Bureau, Ministry of Labour and Employment
Consumer Price Index for Rural Labour (CPI-RL)
1986-87 Labour Bureau, Ministry of Labour and Employment
Consumer Price Index for Urban, Rural and Combined
2010 Central Statistical Organization
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WPI
• Base year 2004-05 (2004-05 = 100)• 676 products (consumer, intermediate and capital) with
value weights assigned:– Rice, wheat, vegetables, petrol, biscuits, textiles, medicines,
cement, TV sets, motor vehicles etc• Services not included• Wholesale prices (not retail prices) from selected
markets• Indices calculated for products/sub-groups/groups/all
commodities by calculating the weighted average of price ratios between the current period and the base year
• Monthly/weekly data published in www.eaindustry.nic.in
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No of products
Weights May, 2011
All commodities 676 100.00 151.7
Primary articles 102 20.12 192.1
Fuel, power 19 14.91 160.4
Manufactured products
555 64.97 137.2
WPI
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Inflation rate
• ((Pt - Pt-1)/Pt-1)*100
• Annual averages:Pt = 52 week/12 month average of the index in a particular year
Pt-1 = 52 week/12 month average of the index of the previous year.
• Year-on-year (point-to point) basis:Pt = Index in a particular week/month
Pt-1 = Index 52 weeks/12 months earlier
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1971
-72
1974
-75
1977
-78
1980
-81
1983
-84
1986
-87
1989
-90
1992
-93
1995
-96
1999
-00
2002
-03
2005
-06
2008
-09
-10.0
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
30.0
Annual Average Inflation rate: CPI and WPI
CPI-IW WPI
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Jan-
07
Apr-0
7
Jul-0
7
Oct-
07
Jan-
08
Apr-0
8
Jul-0
8
Oct-
08
Jan-
09
Apr-0
9
Jul-0
9
Oct-
09
Jan-
10-2.00.02.04.06.08.0
10.012.014.016.018.0
Year-on-year Inflation rate: CPI and WPI
CPI-IWWPI
Year
Per
cen
t
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Nominal/Real Interest rate
Real interest rate =
Nominal interest rate – Inflation rate
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Topic 3
Business Cycles and Multiplier
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Questions
• What causes aggregate income to rise? To fall?
• What causes too little spending – recession and depression?
• What causes too much spending – demand pull inflation?
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Assume: Demand-constrained economy
Aggregate demand
Potential outputK
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In reality
• Given a particular K, an economy necessarily does not produce the maximum possible output
• How much is produced depends on the size of the market
• Most of the recessions in the post World War II can in fact be explained by reductions in aggregate demand
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What are the factors which influence aggregate demand?
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Consumer
spending
Govt exp on
goods & services
Firms
Households
Factor
marketsMarket for goods
& services
Financial
markets
Government
Rest of
World
Wages etc
Imports
Exports
I spending
GDP
Taxes
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Initial assumption
• Closed economy• No government• Two sectors:
– Households– Firms
• Hence two types of aggregate demand:– Consumption and– Investment
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Households, typically
• Use a part of their income for consumption• And save the other part
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Firms
• Investment expenditure:– Planned investment (mainly fixed investment
expenditure, i.e., expenditure on final investment goods such as plant, machinery)
– Unplanned inventory adjustment• Use retained earnings (business savings)
and loans and other sources to fund investment
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Consumption Expenditure
• Depends on:–Current disposable income (DI)–And other factors such as:
• Expected future income• Wealth
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Consumption Function
• Relationship between C and DI, other factors remaining constant
• MPC: marginal propensity to consume = ∆C/ ∆DI = change in C when DI changes by a unit
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Consumption function other factors remaining the same
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Planned Investment Expenditure(= investment spending = investment demand)
• Private Investment undertaken for profits• Private investment demand depends on:
– Revenues generated by the investment project
– Interest rates (and taxes) that influence the costs of investment
– Business expectations about the state of the economy
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Expectations
• Are subjective• Are often influenced by current and
recent rates of return• But can be highly volatile due to
changes in the business climate:• Political, ideological, psychological
and other influences on future expectations
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C
D
EF
G
H
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How aggregate demand determines aggregate output and
income
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Aggregate Demand Curve(=Total Expenditure Curve)
TE (=C+I)
C
Y0
TE
I is constant by assumption
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Assumptions
• Firms produce more (subject to capacity constraints) if market demand is greater than their current production
• Firms produce less if market demand is less than their current production
• (Prices are not changed till full capacity is reached)
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How Aggregate Demand determines Y
TE
Y*
Potential output
Y2
Y1
E1
E2
E*
0
At Y1, Total demand (=E
1Y
1) Total production (=0Y
1=0
1Y
1)
At Y2, Total demand (=E
2Y
2) Total production (=0Y
2=0
2Y
2)
At Y*, Total demand = Total production
Y* is the equilibrium Y
45°
01
02
TE
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Use of 450 lineTE
Y*
Potential output
Y2
Y1
E1 E
2
E*
0
Note: 01
and 02 are in the 450 line
Thus 0Y1 = 0
1Y
1 and 0Y
2 = 0
2Y
2. The 45° line basically helps to compare demand (measured in y-axis) and
supply (measured in x-axis)
At Y1, E
1Y
1 > 0Y
1 and at Y
2, E
2Y
2 < 0Y
2
45°
01
02
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Equilibrium Income level
• Is the level where the system tends to stay• It is not necessarily the optimal level• In the previous example, the equilibrium
point Y* is sub-optimal - it is less than the potential output
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Recessions/Expansions
TE
Y
TE
45-degree line
Y1
Y* Y2
Potential output
Downward shift in
demand
Upward shift in
demand
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Recessions/Expansions
• Exogenous vs Internal cycles• Examples of crises
– New economy bubble in late 1990s– Housing bubble in late 2000
• Crash in real estate:• Investment in housing falls• As business climate worsens, firms reduce I• People affected reduce C
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Impact of Increase of Spending on Income:
Multiplier Analysis
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Multiplier
• A Change in investment spending arising from say a change in future expectations starts a chain reaction in which the initial change in aggregate production leads to changes in consumer spending leading to further changes in production levels.
• Thus production ultimately increases more than the initial increase in investment spending
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ΔExpenditure = ΔI + b ΔI + b2 ΔI +…..(= Δ Demand)ΔProduction (= ΔY ) = ΔI + b ΔI + b2 ΔI +….. = ΔI (1+ b + b2 +…….) = ΔI where b : marginal propensity to consume 0 < b < 1
How multiplier works
1-b
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ΔExpenditure = 10 + b10 + b2 10 +…..(= Δ Demand)ΔProduction (= ΔY ) = 10 + b10 + b2 10 +….. = 10 (1+ b + b2 +…….) = 10 where b : marginal propensity to consume 0 < b < 1If b= ¾, then, ultimately, ΔY = Rs 10(4) = Rs 40
How multiplier worksΔI = Rs 10
1-b
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Multiplier
TE1
Y
TE
45-degree line
Y* Y2
TE2
Potential output
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Fiscal Policy
• Operates through changes in government expenditure and revenue
• Increasing government expenditure was Keynes’ solution to the Great Depression
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Fiscal Policy
• Can play a very important role in recession/depression when investment demand is not very sensitive to changes in the interest rate and monetary policy may not be very effective
• Recall: Interest alone does not necessarily influence I - also important is the expected rate of return
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Expansionary Fiscal Policy
• Upward shift of the aggregate demand curve through:– Larger government expenditure on goods and
services (G ↑) - Keynes’ example of digging trenches and filling them up
– Lower taxes on households (C ↑)– Investment tax credit; lower corporate profits taxes (I
↑)• Output goes up not only due to the initial ↑ in
expenditure but subsequent rounds of increases (recall multiplier)
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Impact of government expenditure
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Effect of Direct Taxes on Consumption Function
Y
C
C1 (post tax C)
C
As direct taxes ↓ , for same Y,
Disposable Y ↑ and
hence C ↑ and vice versa
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Note
• If government expenditure is financed by direct taxes, net demand impact will be less
• During recession/depression, even if government expenditure is financed through printing of money, it may not be inflationary