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Understanding Macroeconomics and its

Relevance
Economics is the study of the use of the scarce resources that have alternative uses. From a practical
perspective, this subject would broadly address how individuals, firms (companies like Reliance,
Airtel, and etc), organizations (non-companies like NGO, education institutions, etc), institutions
(SEBI, NSE, RBI, and etc), and governments make decisions and interact together. Three
fundamental aspects that drive these decisions are:

1. Scarcity: Resources limited relative to desires


2. Opportunity costs: In an environment of scarcity, if one chooses one it may mean giving up
something else. Therefore, the opportunity cost of the choice is the one you gave-up.
3. Efficiency: These scare resources need to be used in an efficient manner.

What is efficiency?
An efficient economy is required to produce its optimum combination of quantity and quality of
goods given its technology and available resources. An economy already producing at an efficient
level can increase the economic welfare of an individual only by decreasing the economic welfare of
another individual.

What are the decisions we are referring?


We are talking about three broad questions that will subsume many questions. Depending on who is
making decisions the context of these questions would be different. Once you understand these
questions you would appreciate how once can use the concept of economics in real life. These
questions are;

1. What products and services needs to be produced and what quantities? Should you spend
more on nutritious food or good books? Should ITC produce more biscuits or more packets
of Aasirvaad Atta? Should government spend more money in subsidising rice or spend the
same money in building canals to irrigate the land?
2. How would one produce these product and services? Should ITC use more labour or
expensive machine to produce biscuits?
3. For whom these products and services are to be produced? Should ITC produce Dark
Fantasy (Rs.60) - to be purchased by the rich or glucose biscuits (Rs.5) to be purchased by
the poor. When ITC makes profit should it give more bonuses to employees or more
dividends to shareholders? Once government can see ITC making lots of profit it can
increase the tax and takes out a portion of the profit. The increase in tax can be spent on
building canal to increase the irrigation, which will increase in productive of land and hence
the income of the farmers.

What are the economic systems in which these decisions are made?
There are three types of economic systems;
1. Market economy (capitalism)
2. Command economy (socialism)
3. Mixed economy
Let us discuss how will ITC decide how much of biscuits to produce?
You may say it will depend on the demand for the biscuits. ITC will estimate the demand from the
market for its biscuits and decide on how much to produce. Over estimation of demand will result in
decrease in price of biscuits and underestimation of demand will results into increase in price of
biscuits. Market will decide what should be the ideal amount of biscuits to be produced. If ITC makes
higher amount of profit other producers will come to market to produce biscuits and profit of ITC
will come down. Therefore, markets will enable the decision making process, and this kind of
economic system is called market economy (capitalism). Similarly, how much should ITC pay to its
employees? Market for labour will decide the right wages.

The market economy will work only when there is perfect competition and markets works perfectly.
However, market may not work perfectly. For example, if no producers come to produce more
biscuits when demand increases, then ITC can charge high prices and exploits the consumers.

The picture below represents how different agents of the economy will interact so that markets will
decide what the market clearing level.

On the other hand if the government believes market will not able to do a good job then it can
decide you may say the government can instruct ITC to produce certain amount of biscuits and what
price to sell them in the market and this kind of economic system is called command economy
(socialism). Similarly government will fix the salary of the employees as well.

In reality most of the economy follows the third kind of economic system is called mixed economy.
In this kind of economy structure government make sure market works perfectly, and no economic
agent is exploited. For example, FSSAI certification, and minimum wage regulation will ensures
consumers and labours are not exploited.

What are the production possibilities?


The production possibilities will depend on the inputs available. These are called factors of
productions. Broadly these factors production can be of three types;

1. Land: Physical assets of the economy provided by the nature including clean air, water, and
forests (broad environment). Newer technology can increase the better use of natural
resources and hence production possibility of the economy.
2. Labour: Human time and effort available for production. Skillsets of the people will define
the productive capacity of the labour. Productivity increase in labour force will increase the
production possibilities of the economy.
3. Capital: It is the resource which forms the durable goods of the economy. These goods are
needed to produce other goods and services. For example, machines, software, technical
knowhow. Increase in stock of capital increase the production possibilities of the economy.

The production possibility frontier studied in microeconomics is the foundation for economic agents
to make decisions with respects to what, how, and whom questions discussed above.

What are the differences between microeconomics and macroeconomics?


Microeconomics deals with how individuals, households, and firms make economic decisions or
behave. Besides, it also studies how market operates. On the other hand, macroeconomics deals
with how the economy as a whole performs. Let us discuss few questions.

Microeconomics questions: How much do you spend per month and how much do you save per
month? How would allocate your money between food and travel or education? Will you work more
if your employer decides to pay you more per hour of work? Will you change your job if paid more?

Macroeconomics questions: What is the total savings of the economy? How would enable
consumers to spend more? How would government allocate the spending between defence and
education? What should be done to make sure all the citizens have jobs? How exchange rate affects
export earnings? How monetary policy affects investments?

How does a macro economy operate?

Household - Supply resources to resource market; earn income


- Demand goods and services from product market - spend income
Firms - Demand resources to produce goods and services
- Payment for resource Supply goods and services to product market - Earn revenue
The Simple Circular-Flow Model for Households and Firms

It refers to a simple economic model which describes the reciprocal circulation of income/
output/expenditure between producers and consumers.
Real Flow- In a simple economy, the flow of factor services from households to firms and
corresponding flow of goods and services from firms to households known to be as real flow. Money
flow is the flow of income and expenditure in money terms
A three sector Model

A Five Sector Model


Thus, it is important to understand what maximum could be produced earned and spent during a
period given resources, factors and technology: Precisely, we are talking about the production
possibilities of a country:. A productionpossibility frontier(PPF)or production possibility curve
(PPC) is a graphical representation of possible combination of two goods (hypothetically two
because we cant present more than that in a graph; in real life its n number)with constant
resources and technology.

Lets understand that:

We are drawing possible combinations of consumer and capital goods that can be produced using all
resources efficiently. These are the possible combinations that a country can produce in an year.
PPF shows increasing opportunity cost. To produce First 10 consumer goods you are sacrificing 5
capital goods and to produce last 10 units you are sacrificing 15 capital goods. Why?

CONSUMER CAPITAL
GOODS (Lakhs GOODS(Lak
of unit) hs of unit)
0 50
10 45
20 38
30 27
40 15
50 0

PPF
60
50
CAPITAL GOODS

40
30
20
10
0
0 20 40 60
CONSUMER GOODS

What are the key objectives of macroeconomics?


The great depression of 1930s provided the seeds of birth of macroeconomics. The study of
macroeconomics is founded by famous economist, John Maynard Keynes. His book The General
Theory of Employment, Interest, and Money provided intellectual fodder for the future economist
to advance the subject.

At a highest level, the objective of macroeconomics is to reduce the volatility of economic activities.
Broadly speaking, there are three objectives;
1. Increasing level of economic activity: Public policy maker need to work towards increasing
the level of economic activities to bring-in growth of output so that citizens standard of
living increases over time.
2. High level of employment: The public policy makers need to ensure that everybody who is
interested in working finds a job suitable for his/her skillsets.
3. Stable price level: Higher inflation eats out the individuals ability to spend and save, hence
the standard of living. Therefore, individuals will like to have a stable prices over time.

The citizens of a country may also want to consume goods and services that are not currently
produced in the country but produced by other countries. Similarly, a firm may want to export its
products to other countries. These export and import activities of an economy increase the
complexities of macroeconomics, and policy makers may have to understand what is happening in
other economies, which is linked to its own economy. This is called effect of globalization on
economic activities.

The policy makers have two broad instruments to meet the objectives of macroeconomics.
1. Fiscal policies: These policies involve the tax and spending policies of governments. These
policies will have effect on spending, saving, and investment activities of the economy.
2. Monetary policies: These policies involve the central bank of the economy, which decides
what should be the money supply, short-term interest rate, and exchange rates. These
policies will have effect on the prices of assets, and hence economic activities.

What are the major macroeconomic variables?


To understand the macroeconomics we need to understand the variables that are available in the
economy. Through these variables we could study the health of the economy. The health of the
economy will drive our public policy decisions for the government. At an individual and household
level these variables will also affect the level of spending and saving. Some of the important macro-
economic variables are;
1. Total output produced
2. Potential output that can be produced
3. Composition of output
4. Growth rate of output
5. Unemployment rate
6. Inflation rate
7. Interest rate
8. Total export
9. Total import
10. Exchange rate
11. Savings
12. Investment etc.