MODULE 1: Macro Economic System

and its Management.

Ref: Darnbusch, et, al.ch.1

0
1. Macro Economic Concerns:

• Micro vs Macro Economics.

• Micro Economics: A study of individual
economic units and their interactions.
• Macro Economics: A study of aggregates
and economy as a whole: National output,
inflation, unemployment, balance of payments
etc.
• Major Building Blocks of Macro
Economics: Model building
1) AD & AS
2) Four Sectors: HHS, BS, GS & FTS
3) Two Markets: Commodity Market
and Money Market.

• Specific issues to be addressed in Macro

Economics:

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 o Rising Prices
o Rising Unemployment
o Falling GDP
o Balance of Payments Crisis.

• Tools of Macro Economic Policy and

Management:
o Fiscal Policy
o Monetary Policy
o Other Policies: Trade, Price and
Labour Policies.

2. The Key Macro Economic Concepts:

• Aggregate Supply (AS) Curve:

o Describes, for each given price

level, the quantity of output firms are willing
to supply.
o AS: Upward Sloping ⇒ Firms
willing to supply more output at higher
prices.

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 P
l

AS
ve
Le
ce
Pri

O Y
Output
o ADC: Shows the combinations of
the price level and level of output at which
the goods and money markets are
simultaneously in equilibrium.

o ADC: Downward Sloping ⇒ At

higher prices, reduction in the Value of
money supply, demand for output is
reduced.

P
l
ve
Le
ce
Pri
AD
O Y
Output

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 o Equilibrium level of output and
the equilibrium price level: Medium Run
AD and AS curves.

l AS
ve
Le
ce P0 E
Pri
AD

O Y
Y0 Output

P0 = Equilibrium Price Level

Y0 = Equilibrium Level of Output.

o Shifts in ADC and ASC:

Case 1: A Rightward shift in ADC due to an
increase in nominal money stock.

l AS
ve
Le P1 E1
ce P0 E
Pri AD1
AD

O Y
Y0 Y1 Output

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  Observe new point of
equilibrium (E1) and new levels of
equilibrium price (P1) and output (Y1).

Case 2: A leftward shift in ASC due to oil

price hike or due to drought.
P
AS1
l AS
ve E1
Le P1
ce P0 E
Pri

AD
O Y
Y1 Y0 Output

 Observe an increase in P and

decrease in output.

o Short run horizontal ASC: The

Keynesian Case

P
l
ve Assumption:
Le Unemployment
ce AS of resources
Pri

O Y
Output

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• The Classical vertical ASC:
P
l AS AS*
ve Assumption: Full
Le employment of
ce resources
Pri

O Y
Y* Y**
Output

 ASC: Shifts right right due

to growth of output overtime.

• Consider shifts in AD due to an increase

in money supply (monetary expansion) and
an increase in government expenditure (G)
– fiscal expansion.

Case 1: The Keynesian Case:

P
l
ve ⇒ An increase in
Le E E1 output, but
no ce
Pri AS change in
AD1 price level
AD
O Y
Y0 Y1 Output

Case 2: The Classical Case:

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 P
l AS
ve P1 E1 ⇒ An increase in
Le P, but no
ce P0 E change in
Pri AD1 output
AD
O Y
Y* Output

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• Growth of output (say GDP), Inflation
and unemployment:

o Potential output (Trend level of

real GDP): Max amount of output that an
economy can produce while maintaining
price stability.

Trend

o Output fluctuates around

potential output or the trend level of real
GDP.

o Output Gap (O G) = PO – AO ⇒
Difference between potential output (full

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 Employ
ment level of output, given the
existin
g resources) and actual output
 PO = Potential Output
 AO = Actual Output.
>
o OG = O ⇒ ?
<
o Inflation: Details later
o Inflation and output gap:
λ = Pt – Pt-1 = Inflation rate
Pt-1
<
λ = O ⇒ ?
>
o Inflation rate and output gap:
Inverse relationship?

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 o Rate of unemployment and rate
of inflation:
(%)
tion
Infla
in
nge
cha
of
Rate Philips Curve
O U E Rate (%)

o Unemployment rate and GDP

relationship: Okun’s Law
(%)
GDP
real ⇒ Inverse relationship.
of (Always ?)
Rate ⇒ Vital link between output
wth and labour market.
Gro

O Change in unemployment rate (%)

o U E R (%) = No. Unemployed X

100
Labour Force
o Labour Force = No. Employed +
No. Unemployed.

Module 2: National Income: Concepts and

Measurements

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Ref: 1. Durnbusch et. al, Ch.2
2. Mankiew Ch.2

• Formal structure for Macroeconomic

Models:
o Production Side: AS
o Demand Side: AD

• A measure of overall price level: Study of

inflation.

• A measure of performance of Macro

economy: GDP – The most comprehensive
measures of total output in the economy.

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 • Two definitions of GDP:
o GDP: Market value of all final
goods and services and total expenditure on
nation’s output.
o GDP: Sum of all factor payments
⇒ Total income.

• Two amplifications to the definition of

GDP:
o Value of output currently
produced
o Include only the value of final
goods and services – value of intermediate
goods not included.

Sale Value added

Income
Value by each
Product generate
(Rs./Unit industry
d
) (Rs.)
Bread →
20 9 9
Baking industry
Flour →
11 5 5
Milling industry
Wheat →
6 5 5
Agriculture
Fertilizers, seeds etc. 1 1 1
→

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Chemical industry

Total 38 20 20

 Value of output = 20
 Value of income = 20.

 Compare this with two

definitions of GDP.
• GNP = GNI : GNP estimated on the basis of
product flows and GNI estimated on the
basis of income flows (wages, interest, rent,
profit etc) see columns 3 & 4 of tables.

• Three Methods of Measuring National

Output:

o Income Received Approach:

Y = Yω + Yγ + Yi + YΠR + YΠD

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 o Expenditure Approach:
Y=C+I+G+X–M
⇒ Aggregate Demand.

o Value of Product Approach:

Y = P1Q1 + P2Q2 + - - - + PnQn
n
= Σ PiQi
i=1

• Nominal and Real GDP:

o NGDP: GDP at current prices

1992 1998
Commodi
NGD NGD
ty Q P Q P
P P
1.0
X 1 1.00 2 2 4.00
0
0.7
Y 1 0.5 0.50 3 2.25
5
1.50 6.25

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 Why change in NGDP
from 1.50 to 6.25?
 Quantity effect
 Price effect.

 To make valid
comparisons between 1992 and 1998, compute
GDP at constant prices – called Real GDP.

Q P
Commodi RGDP
(199 (199
ty (1998)
8) 2)
X 2 1.00 2.00
Y 3 0.50 1.5
Total 3.50

⇒ Change in GDP in 1998 due to price

increase is eliminated by estimating
GDP at constant prices viz price of 1992.

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 GDP Deflator: A
useful measure of inflation.
GDPD = (NGDP) 1998 = 6.25 = 1.785
(RGDP) 1998 3.50
= 1998 GDP at current prices
1998 GDP at constant prices

 GDPD: Measures the

change in prices→79% increase in NGDP is
due to inflation.
• Other Measures of National
Output/Income

o GNP = GDP + factor payments

from abroad – factor payments to abroad
o NDP = NNP = GDP –
Depreciation
o NI = NDP = NNP – indirect
business taxes (Sales Tax, Excise Tax,

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 Custom Duties). Then only factor payments
will be made.
o PI = NI – Corporate Π – Social
Insurance Contributions + Dividends +
Government Transfer Payments + Personal
Interest Income
o DPI = PI – Personal Income Tax
and Non-Tax Payments.

• Problems of measuring GDP:

o Service of parents to Children (say child
care): Valued at Zero ⇒ Non-market
productive activities left out.
o Difficult to account correctly for
improvements in the quality of goods.
o Home made food: Value of family
labour used, not included. If made in
Hotel, value of labour included.

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o Use of resources to avoid or contain
“bads” (crime or risk to national security)
added to GDP. Should they be?
o Underground economy left out: ex: -
illegal forms of economic activities like
drug trade and gambling.
o Not subtracted from GDP the cost of
environmental pollution and degradation.

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 • Is GDP an adequate measure of overall
social welfare?

“It should be no surprise that national

prosperity does not guarantee a happy society,
any more than personal prosperity ensures a
happy family. No growth of GDP can counter
the tensions arising from an unpopular and
unsuccessful war, a long overdue self-
confrontation with conscience on racial
injustice, a volcanic eruption of sexual mores,
an unprecedented assertion of independence by
the young. Still, prosperity is a precondition
for success in achieving many of our
aspirations” Arthur Okun, “The political
Economy of prosperity” (1970).

• Inflation, the Consumer price index (CPI) producer

price index (PPP) and GDP deflator (GDPD):

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 o Inflation:
λ (%) = Pt - Pt-1 x 100

Pt-1
λ = 0 ⇒ stable P
λ > 0 ⇒ Rising P
λ < 0 ⇒ Falling P

o CPI:

 Cost of buying a given basket of goods

and services → Measures Cost of living.
 CPI: An explicit price index → Directly
measures movement of weighted average
prices of goods and services bought by
consumers at retail level.
 Government pensions and wage rates etc:
Indexed to the CPI.
 An example to illustrate measurement of
CPI.
o Assume: Consumers buy three
commodities, viz. food,

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 shelter / clothing, and
medicare.

: 50 % of income on
shelter / clothing
30 % medicare
20 % Food

: Set prices of each

commodity as 100 so that
differences in unit prices
do not affect the price
index.
o CPI = (0.50 x 100) + (0.30 x 100) + (0.20 x 100) =
100
o Plus CPI for base year : 100
o Let food prices rise by 2 % → 102
Shelter prices rise by 6 % → 106
Medicare prices rise by 10 % → 110

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 Say during 1999 compared to base
year.
o Calculate CPI for 1999:

CPI1999 = (0.50 x 106) + (0.30 x 110) + (0.20

x 102)
= 53 + 33 + 20.4
= 106.4

o Hence λ = 106.4 – 100 = 6.4

100

= (CPI) current year – (CPI) last year

X 100
(CPI) last year
 GDPD vs CPI:
o GDPD measures price change of wider
group of goods & services
o GDPD: Considers only prices of goods
and services prices of goods and services
produced in the country.
o CPI: Includes the prices of imports also.

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o GDPD: Basket of goods and services
vary every year.
o CPI: same basket of goods and services
during a given period.

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 PPP:
o Measures wholesale prices, including
the prices of raw materials and semi
finished goods → wider coverage of
PPP.
o Movement PPP signals movement in
retail prices, such as those measured
in CPI

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