part i 1 introduction macro economic 512011

8/4/2019 Part i 1 Introduction Macro Economic 512011

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BASIC CONCEPTS OF MACROECONOMICS

PART 1: AN INTRODUCTION TO MACRO

ECONOMICS


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WHAT DO YOU UNDERSTAND BYMACRO ECONOMICS?


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Macro Economics: Macro Economics is that branch of economicswhich studies the aggregate behaviour ofeconomic system.

Micro economics deals with the

Division of total output among individual unitsAllocation of scarce resources and pricing of

particular product.

While macroeconomics studies the gross or totalnational product, aggregate national income and

general price level.



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IMPORTANT EXAMPLES:

NATIONAL INCOMESAVINGSINVESTMENTSEMPLOYMENTBALANCE OF PAYMENTS: EXPORTS, IMPORTS,TRADE BALANCEEXCHANGE RATEINFLATIONBUSINESS CYCLES



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CONSTITUENT GROUPS OF ECONOMY: BASICSOF MACRO ECONOMIC ANALYSIS.

HouseholdsThe firmsThe GovernmentThe rest of the World.THEIR INTERACTION WITH EACH OTHER LEADSTO RECEIPT OR PAYMENT OF INCOME.



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REST OF THE WORLD


FIRMS(Sell goods & services to

Household & Govt. They receive

Payments; Firms also pay wages

Int and dividends to households

Pay taxes to Govt.)

GOVERNMENT(Collect taxes from households and

Firms, Buys goods and services from

Firms , pay wages and int. to house

Holds; makes transfer payments to

Households

HOUSEHOLDS(Receive income from firms and

the Govt.; purchase goods &

services from firms; also receive

transfer payments, interests,

dividends)

Wages, Interest, Dividends, Profits & Rent

Wages, Interest, Transfer Payments.

Purchase of Goods & Services Taxes

Taxes

Purchase of Goods & Services

Purchases of foreign made

goods (services) and services

by locals

Purchases of domestically made

goods and services by locals


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MARKETS


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Economies are generally characterised by thefollowing 3 markets:

Goods and Services Market

Labour Market

Money Market

MARKETS IN AN ECONOMY


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FIRMS GOVERNMENT HOUSEHOLDSHOUSEHOLDS

Goods &

Services MarketsLabour Market Money Market


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Goods and Services Market:

Households + Govt. Purchase goods andservices from firms in Goods & Serv. Market.

Firms also purchase goods and services fromeach other.

Firms supply to the goods and services market.

Household supplies labour and firms and Govt.demand them.

Rest of the World both buys from and sells tothe goods and services market.



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Savings from households is sometime termed asa leakage from the income or currentpurchasing power because it withdraws incomeor current purchasing powerfrom the system.

Firms supply to the goods and servicesmarket.

Households + Govt. + Firms

Demand from thismarket.

Rest of the world both buys from and sells tothe Government Goods and Services Markets.



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Labour Market:

HouseholdsSupply Labour Firms and Govt. Demand Labour Rest of the world also demand and supplies

Labour .

Individual to decide to enter in the labourmarket and for choosing working hours.

In recent times Labour has also become asInternational market.



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Money Market: Households Purchase stocks and bonds fromfirms.

Households Supply funds to Financial/MoneyMarkets.

Firms Borrow to build new facilities in thehope of earning more in future.

Govt. Borrows by issuing bonds Rest of the World both borrows from and

lends to the money market.



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Borrowings and lending of households,Government, Firms and Rest of the world iscoordinated by Financial Institutions: viz

Commercial Banks Development Finance Institutions

Non banking finance companies Savings and Loan Associations Insurance Companies(These institutions take deposits from one group

and lend them to others)



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Rate of Interest plays crucial role in MoneyMarket since on borrowings/loan interest is tobe paid.

Promissory notes are signed by borrowers to

return money to the lender.

Firms can raise funds through issue of shares.

Share is a financial instrument that gives

ownership of a firm to investor and hence rightto share profit.

Share Price and amount of dividends canincrease or fall depending on the performance ofthe company.



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GDP We will discuss in detail. Here only fewobservations: GDP is the total market value of a nationsoutput.

It is the market value of all final goods andservices produced within a given period of timeby factors of production located within thecountry.

It is a monetary measure arrived at by findingthe sum total of the value of products ofquantity produced in any specific year.

GDP


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GDP as a measure of the total production of aneconomy acts as an economic barometer of anation.

GDP


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GROSS DOMESTIC PRODUCT(GDP)


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GNP VERSUS GDP: Both measure the total market value of all thefinal goods and services produced in aneconomy in one year.

The difference between them is only in how theeconomy is defined.

While GNP comprises the total output producedwith the resources of a nation regardless ofwhether these resources are located in thatnation or abroad, GDP relates to the value oftotal output produced within the boundaries of anation whether by resources of the nation orforeign nations.

GDP


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For most nations the difference between GDPand GNP is small.

GDP


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GDP Computation can be done in two ways:

To add up the amount spent on all final goodsduring a given period.

This is EXPENDITURE APPROACH TOCALCULATING GDP.

The other is to add up the income i.e. wages,rents, interest and profits received by all factorsof production in producing final goods.

This is the INCOME APPROACH TOCALCULATING GDP.

CALCULATING GDP


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These two methods lead to the same value ofGDP because every payments (expenditure ) bya buyer is at the same time a receipt (income)

for the seller.

CALCULATING GDP


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The Expenditure Approach:

Corresponding to the four main constituentgroups in an economy households, firms, thegovernment and the rest of the world GDP iscomprised of these expenditure components:

GDP = Personal Consumption Expenditure (C) +Gross Private Investment (I) + Government

Purchases (G) + Net Exports (X)

CALCULATING GDP


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PERSONAL CONSUMPTION:

Expenditures by consumers on goods andservices.

3 main categories of expenses: Durable Goods (viz. automobiles, furniture andappliances lasting relatively longer time)

Non Durable Goods (Food, clothing andcigarettes used up fairly quickly)

Payments for services (viz. payments toDoctors, lawyers and educational institutions)

CALCULATING GDP


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GROSS DOMESTIC INVESTMENTS (I):

Purchase of new capital such as housing, plantsand equipment and inventory.

Investment can be both by the private sectoraswell as public sector.

Private sector investment is generallycategorised into residential and non residentialinvestment.

Expenditure on machines, tools, plants etc. istermed as non residential investment.

CALCULATING GDP


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Change in Business Inventory is the thirdcategory. They are goods produced by thecompanies with the intention of selling at a laterdate.

Net investment is a measure of the change inthe stock of capital during a period.

GOVERNMENT PURCHASES (G):

It includes newly produced goods and servicesby central state and local governments.

CALCULATING GDP


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It include any goods that the governmentpurchases plus the wages and salaries of allgovernment (It is a payment that the

government makes to the employees when itpurchases their services as employees).

NET EXPORTS:

Net Exports are total exports minus total imports. Net exports can be positive ornegative.

CALCULATING GDP

GDP = C + I + G + X


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INCOME APPROACH:

The income approach to calculating GDP looksat GDP in terms of WHO RECEIVES IT ASINCOME AND NOT WHO PURCHASES IT.

GDP = National Income (N) + Depreciation (D) +Indirect Taxes minus Subsidies (T) and Net

factor payments to the rest of the world ( F).

GDP = N + D+ T + F

CALCULATING GDP


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NATIONAL INCOME (N):

Total Income earned by factors of productionowned by a nations citizens.

When output is produced, income is created. The Income that flows to the private sector is

called national income.

NI = Compensation of employees + Proprietorsincome+ Corporate profits + net Interest andRental Income.

CALCULATING GDP


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Compensation of employees is the largest of thefive items includes wages and salaries paid to

households by firms and by the government.

CALCULATING GDP


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PROPRIETORS INCOME is the income of un-incorporate businesses and

CORPORATE PROFITS are the income ofcorporate businesses.

NET INTEREST is the interest paid by business. RENTAL INCOME a minor item is the income

received by property owners in the form of rent.

CALCULATING GDP


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Thus NATIONAL INCOME IS THE AGGREGATEFACTOR INCOME THAT ARISES FROM THECURRENT PRODUCTION OF GOODS AND

SERVICES AND SERVICES BY THE NATIONSECONOMY.

CALCULATING GDP


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DEPRECIATION (D): The measure offall in values of capital assets iscalled depreciation.

Since national income includes corporate profitsafter the depreciation (i.e. it has been deducted)so depreciation must be added back.

INDIRECT TAXES SUBSIDIES (T):

Since indirect taxes are counted on theexpenditure side, they must also be counted onthe income side.

CALCULATING GDP


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SUBSIDIES:

They are payments made by the Government forwhich it receivesno goods or services in return.

These subsidies are subtracted from nationalIncome to get the GDP.

CALCULATING GDP


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NET FACTOR PAYMENTS TO THE REST OF THEWORLD:

Net factor payments to the rest of the world equalthe payments of factor income to the rest of theworld minus the receipts of factor income from the

rest of the world.

CALCULATING GDP


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For analysis of equilibrium of GDP followingassumptions are made:

1.GDP is ultimately determined by Aggr.Demand

2.Investment spending is constant with respect tochanges in Income and

3.Consumption increases with the level of Income.

EQUILIBRIUM LEVEL OF GDP is determinedthrough the equation ofAggregate demand andAggregate supply:

GDP EQUILIBRIUM


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AGGREGATE DEMAND represents theexpenditure that the households and the firmsare undertaking on consumption andinvestment:

Aggregate Demand = Consumption Demand +

Investment Demand. [ Y = C + I ]

Consumption Demanddepends on:

Income and Propensity of community toconsume.

GDP EQUILIBRIUM


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Investment Demand:

Is a function of the Marginal Efficiency ofCapital means expected rate of profit that thefirms hope to get from the investment in capitalassets and Interest.

AGGREGATE SUPPLY: Total Money value of goodsand services produced in the economy i.e.

GDP EQUILIBRIUM


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It comprises ofOutput of final consumer goodsand services and the output of capital orinvestment or producer goods.

Aggregate Supply of goods in an economydepends upon the stock of capital, the amountoflabourand the state of technology.

Aggregate Supply represents GDP since bothrepresent the value of output of final goods andservices produced.

GDP EQUILIBRIUM

DETERMINATION OF GDP (GDP


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Expenditure =Output 450

Consumption Function C

C + I (Total Spending)

Demand

N* Output (income), N

TotalSpendi

ng=Out

put

Aggregate Demand[ EFFECT IVEDEMAND ] =Aggregate Supply

EEffectiveDemand

DETERMINATION OF GDP (GDPEQUILIBRIUM)

PLOT C; ADDCONSTANT I

GET TOTAL SPENDING

EQUILIBRIUM GDP


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EQUILIBRIUM GDPCALCULATION

Output

(Income)

Consumption

C

Savings

S

Investment

I

AggregateExpdt.(C+I)

100 105 -5 10 115

120 120 0 10 130

140 135 5 10 145

160 150 10 10 160

180 165 15 10 175

200 180 20 10 190

GDP EQUILIBRIUM (KEYNESIAN


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Simplest Model to explain how demanddetermines output in the short run.

It is a graph with the demand for goods andservices represented on the vertical axis, output(income) represented on the horizontal axis anda 450 diagonal line representing a key

relationship between demand and output.

ASSUMPTIONS: Neither the Govt. nor Foreign Sector exist.

GDP EQUILIBRIUM (KEYNESIANCROSS)

GDP EQUILIBRIUM (KEYNESIAN


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Only consumers and firms can demand outputwhere consumers demand consumption goodsand firms demand invest goods.

Consumption and firms each demand a fixedamount of goods.

Output = Demand = C + I On the demand output diagram line representing

demand (C+ I) is superimposed. E is equilibrium point where output measured onthe horizontal axis equals demand by consumers

and firms measured on the vertical axis.

GDP EQUILIBRIUM (KEYNESIANCROSS)

GDP EQUILIBRIUM (Kenynesian


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450

C + I

Demand

Output (income), N

E

GDP EQUILIBRIUM (KenynesianCross)

N*

E1

E2

N2

N1


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Expenditure=Output

C + I + G

C + I + G

C + I + G

InflationaryGap

DeflationaryGap


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Algebraic Analysis:

N = C + I

Consumption function is defined as under:C = a + bN

Hence Y= a + bN + I

(1 - b) N = a + 1N = (a + 1) / (1 - b)N = 1/ (1-b) [ a + 1 ]

This indicates Equilibrium Income.

GDP EQUILIBRIUM

AGGREGATE EXPENDITURE


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AGGREGATE EXPENDITURETHEORY

The theory explains:

1. How an economys equilibrium real GDP relates to thetotal spending and

2. How a change in total spending affects the level of real

GDP.Assumptions:

1. Closed Economy i.e. the one where there are nointernational trade transactions

1. Economy is private economy i.e. Govt. Sector does notexists

2. All Savings are personal savings

3. Depreciation and net foreign factor income are zero.



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The aggregate expenditure theory implies that theamount of goods and services produced or the level ofemployment in an economy depends directly on the levelofaggregate expenditure.

Workers and machinery are idle when there are no

markets for the goods and services that they canproduce.

For better appreciation of theory we need to havedeeper understanding of consumption and savings

CONSUMPTION AND SAVINGS:N = C + S

Savings is done at the cost ofadditional spending.

Savings and investment may not necessarily be equal

GDP EQUILIBRIUM (Kenynesian


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450

Demand

Output (income), N

GDP EQUILIBRIUM (KenynesianCross)

E1

N1

Consumption

S

C



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Consumption Function:Consumption function is defined as under:

C = a + bN

C- Consumption Spending of Income

a and b are constant.

a- Part of consumption that is independent of Income(Necessities i.e. food, clothes etc.)

Such Expenses independent of income is also known asAutonomous Consumption

bMarginal Propensity to consume. (how muchconsumption spending change for every rupee changein income)


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Consumpt

ion

Output (Income)

Consumption Function

Consumption Function

C = a + b Y

Autonomous

Consumption

Slope=bb


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Output (Income)

Shifting/Change inConsumption Function

a

a

C(Slopeb=b )-

C(Slope b)C(Slope b)

C(Slope b)

Output (Income)

Consumption Consumption

Increase in MPC without

Any change in a will

change the consumption

function

Increase in Autonomous Exp. will shiftentire consumption function



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Autonomous Consumption can change due toseveral reasons such as a change in consumerwealth, a change in consumer confidence etc.

Marginal propensity to consume can change dueto consumers perceptions of changes in theirincome and changes in tax rates etc.



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SAVINGS: When all that is earned is not spent there could be

Savings.

Excess of Income over Consumption : S = Y-C

Savings depends on propensity to save:

PC (Prop.to consumer S/N) + PS (Propensity to Save)-1hence PS = 1- PC

Savings = Households Savings + Firms Savings

(Deducting dividends from profits) + GovernmentSavings (Public Revenue Public Expenses).

Factors affecting Savings: Income; Distribution ofIncome; rate of interest ; population; consumptionpattern; Political Stability

CONSUMPTION SCHEDULE


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Consumption

Income

CONSUMPTION SCHEDULE

EConsumption

Savings C

Break Even Income

C

Dissavings

SAVING SCHEDULE


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Savings

Income

SAVING SCHEDULE

N1

Saving Schedule

Savings

S

O BreakevenIncomeDissaving



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OutputLevel

Consumption C

SavingsS (Y-C)

APCC/Y

APSS/Y

MPC MPSdeltas/delta Y

100 105 -5 1.0500 -0.0500 - -

120 120 0 1.0000 0.0000 0.75 0.25

140 135 5 0.9643 0.0357 0.75 0.25

160 150 10 0.9375 0.0625 0.75 0.25

180 165 15 0.9167 0.0833 0.75 0.25

200 180 20 0.9000 0.1000 0.75 0.25



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AVERAGE AND MARGINAL PROPENSITIES APC = Consumption /Income = C/N APS = Savings/Income = S/NAPC falls with the increase in income ;

APS rises as the income increases .

The fraction of total income that is consumed, declinesas the income rises and the fraction of income that issaved rises as the income increases.

APS + APC = 1

MPC= Change in Consumption /Change in Income

MPS = Change in Savings/ Change in income

MPS + MPC = 1



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FACTORS AFFECTING CONSUMPTION/SAVINGS:

WEALTH

INDEBTNESS TAXATION AND AVERAGE SIZE AND AGE OF HOUSEHOLDS Generally it is observed that the amount of

consumption increases with the increase in wealthaccumulated by the households. For obvious reasonsthe amount of saving will decrease in such a case.

Wealth means both real as well as financial assetsthat the households own.

R l d Fi i l A t


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Real and Financial Assets

Real Assets Financial Assets

HOUSE CASH

CAR SHARES

TELEVISION BONDS

FRIDGE BANK DEPOSITS

COMPUTER GOVT. SECURITIES

INVESTMENT


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INVESTMENT:

It is the addition to the total physical stock of capital Buying securities which is commonly referred to as

investment is not really investment.

It is merely a change in the ownership of assets thatalready exist.

In Economics Investment signifies the new expenditureon addition of capital goods and inventories.

Investment raises aggregate demand and in turnincreases the level of in income and employment in theeconomy.

INVESTMENT

INVESTMENT


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Private Investment depends on Marginal Efficiency ofCapital (MEC) and the Available Rate of Interest (ARI).

Investment will be made only when the MEC is greaterthan the ARI.

Marginal Efficiency of capital is the discounting rate thatequates the present value of the cash flows generatedby an investment project to the present value of cashoutflows that is the cost of that investment project.

INVESTMENT

INVESTMENT


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EQUALITY BETWEEN SAVINGS AND INVESTMENT:

By definition in actual sense Savings and Investment arealways equal. However they are equal only in equilibrium. An Economywill be in equilibrium when the aggregate level of

investment equals the aggregate domestic savings.

Suppose Savings increases Consumption will decline Inventories with the manufacturers and/or traders willrise This addition to the inventories though notplanned will raise the level of investment Thus

investment will become equal to savings & vice versa.

INVESTMENT

S= IS>IS


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REAL INTEREST RATE: Nominal interest rate Rate of Inflation The real rate of interest rather than the nominal interestrate is crucial in making investment decisions.

INVESTMENT

Expected rate of net profit/Real Int. rate

Investment

Investment Demand Curve

INVESTMENT


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Other factors which affect Investment decisions:

Acquisition and operating costs for machines Corporate Taxes Technological change Future Expectations.

INVESTMENT


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UNEMPLOYMENT

UNEMPLOYMENT


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Why Full Employment?

All economies seek to achieve full employment andeliminate unemployment.

Employment refers to the condition where large numberof able bodied persons of working age who are willing towork can get work at current wage levels.

Full Employment may be defined as a situation whereinall those who are willing and able to work at the

prevailing wage rate are in fact employed for the work inwhich they are trained.

In the state of full employment, when all existingresources are fully and efficiently employed output will

be maximum.

UNEMPLOYMENT

UNEMPLOYMENT


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Employment refers to the condition where large numberof able bodied persons of working age who are willing to

work can get work at current wage levels.

When such persons cannot get work it is considered tobe a case ofunemployment.

When persons are only partially employed or areemployed in inferior jobs though can do better ones, saidto be underemployed.

UNEMPLOYMENT

UNEMPLOYMENT


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Unemployment refers to any unused resource whetherland, labour or capital.

In each case a cost to the economy is involved. In the production side of the national accounts the cost

is the value of commodities that could not be produced

. While on the income side of the account the cost is loss

of wages and salaries, rent and interest for labour, landand capital respectively.

Of all resources, labour is the one on which mostattention is concentrated .

UNEMPLOYMENT

UNEMPLOYMENT


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Reasons for such concentration:1.Statistics on unemployed labour serves as a

fairly reliable indicator of total unemployment.

2.Costs ofhuman unemployment are usually more

obvious and dramatic than the costs of otherkinds of unemployment.

3. Labouris usually the sole productive resourcethat a household has to sell.

4. When labour resources are unemployed there isloss of total future output.

5. Human resources depreciates more quickly

than other kinds of resources.

UNEMPLOYMENT

UNEMPLOYMENT


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More Specific Meaning of Unemployment:

Unemployment refers to the situation where a person isnot employed but is available for work and has made

specific efforts to find work during the previous fourweeks.

A person not looking for work, either because he or shedoes not want a job or has given up looking for a job isclassified not in labour force.

People not in labour force include full time students,retirees and those staying home to take care of childrenor elderly parents.

UNEMPLOYMENT

UNEMPLOYMENT


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Total labour force in the economy is the number ofpeople employed plus the number of people unemployedthat is:

Labour Force = Labour Force + Not in labour force Unemployment Rate = Unemployed/ (Employed + Non

Employed)

The ratio of the labour force to the population 16 yearsold or overis called the Labour force participation rate

Labour Participation Rate = Labour Force /Population.

UNEMPLOYMENT

TYPES OF UNEMPLOYMENT


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TYPES OF UNEMPLOYMENT:

Frictional Unemployment: It is unemployment thatoccurs during normal working of an economy.

It is not possible for every worker to be employed everysingle working day of his life.

Some will voluntary switching jobs, others will have beenfired and are seeking reemployment

Some would be temporarily laid off from their jobs due toother factors.

Frictional correctly implies that the labour market is notperfect or instantaneous that is it is not without friction

in matching worker and the job.




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FACTORS:

People change jobs , move across the nation, get laid offfrom their job, takes time for search of jobs.

As jobs become more and more complex and the numberof required skills increases matching skills and jobsbecomes more complex and the frictional unemploymentrate may rise

Seasonal Unemployment: When a particularproductiveactivity is seasonal in nature and the persons employedin it, become unemployed during the slack season thetype of unemployment is called seasonal unemployment.

Frictional Unemployment is inevitable and sometimesdesirable.




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STRUCTURAL UNEMPLOYMENT:

Unemployment due to changes in industrial structure,structure of consumer and in technology altering thestructure of total demand for labour.

Demand for skills alters; some skills becomes obsoleteand somejobs need new skills.

Reluctance of workerto move to new locations also leadto unemployment. Such workers are potentiallyemployable but firm in their area is willing to pay thesalaries they demand for the skills that they possessed.




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Although the unemployment that arises from suchstructural shifts could also be classified as frictional, itis usually called Structural Unemployment .

The distinction between frictionally unemployed andstructural unemployment is hazy.

However, the main difference is that frictionallyunemployed workers have saleable skills, whereas thestructurally unemployed workers are not readily reemployable without retraining, additional education andpossibly geographic relocation.

Frictional unemployment is used to denote short run job/skill matching problems that last a few weeks.




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Structural unemployment on the other hand denotes longrun adjustment problems that tend to last for years.

Cyclical Unemployment:

The increase in unemployment that occurs duringeconomic recessions and depressions is called cyclicalunemployment.

During recession the effective demand decreases. As aresult in owners to survive in the businesses reducetheir production.

Some factors of production thus become unemployedcausing the cyclical or Keynesian unemployment.




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Level of unemployment may be linked directly to thelevel of total spending.

When spending decreases business firms must cut backon production and consequently they are unable to buyas many resources including labour as offered for sale.

A recession causes a decline in real GDP or real output. Cyclical Unemployment rises during periods when real

GDP or economy grows at a slower than normal rate and

decreases when economy improved .

As the overall demand for goods and services decreases,employment falls and unemployment increases.

For this reason the cyclical unemployment at times isalso called deficient unemployment.




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COSTS OF UNEMPLOYMENT:

Economic losses to both society and individuals.

Excess unemployment means that the economy is nolonger producing at its potential.

Social loss translates into reduced income and loweremployment for individuals.

When unemployment increases more workers are fired orlaid off from their existing jobs and individuals seekingemployment find fewer opportunities available.

To families with fixed obligations such as mortgagepayments the loss in income can bring immediatehardships.




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The costs of unemployment are not simply financial. A persons status and position are largely associated

with the type ofjob the person holds.

Losing a job can impose severe psychological costs. Some studies have found that increased crime, divorce

and suicide rates are associated with increasedunemployment.

EMPLOYMENT STRATEGIES: Growth oriented Strategies Wage goods strategy Labour intensive technology strategy and Rural public work strategy of employment.



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BUSINESS CYCLE

BUSINESS CYCLE


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BUSINESS CYCLE

GROWTH CYCLES:

Change is a universal phenomenon and businessare no exception.

Whenever they are affected by the externalenvironment which itself is highly volatile theycannot remain constant for all times.

No nation can have a steady economic growthin the long run.

BUSINESS CYCLE


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BUSINESS CYCLE

The economic growth will intermittently beinterrupted by periods of economic instability.

Conventional Business Cycle analysis has beenuseful in the Industrially Developed countrieswhich have generally experienced shortexpansionary and contractionary phase in thelevel of economic activities resulting in lowaverage growth rate.

Developing and emerging market economiesexperience continuous expansion or contractionin the level of economic activities.

BUSINESS CYCLE


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BUSINESS CYCLE

Trend component of the series selected fordepicting the fluctuations turn out to be sosignificant that it becomes difficult to visuallydiscern the cyclical component even after

accounting for seasonality.

In such economies certain indicators ofeconomic activities increases so rapidly that itappears that there are no recessions that theeconomy is witnessing a continuous expansionover a very long period of time.

BUSINESS CYCLE


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A closer analysis using slightly different toolsreveals that cyclicity does exist even in these

cases though they are not apparent.

A growth cycle is a plot of the deviations of theactual growth rate of the economy from its longrun trend rate of growth or the full employmentoutput

BUSINESS CYCLE

PHASES OF GROWTH CYCLES


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A Business cycle consists of a period ofeconomicexpansion followed by a period of economiccontraction.

PHASES OF BUSINESS CYCLE:

1.Expansion Peak

2. Contraction (Recession) Trough

(Phases: Recovery, Expansion, Slowdown andRecession)



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A recession is roughly a period in which realGDP declines for at least two consecutivequarters.

An expansion isjust reverse. When recession becomes severe it is known as

depression.

Investment spending, Consumption and sharepricesare all pro-cyclical.

Unemployment is counter cyclical.



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RECOVERY:Usually cycle picks up from trough.

Rate of growth remains lower than what ispossible at the full employment level of output.

Mild Increase in prices

Inflation rate increases as the economyapproaches the trend line or full employment

line.

Mild increase in the inflation rate below the fullemployment level of output is known as

reflation



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EXPASION:

Economy expands at the rate of growth which ishigher than the rate of growth at full

employment level of output.

Rapidly increasing inflation rate.

Economy crosses the full employment level ofoutput Level of output, the wages and otherprices start rising at a rapid rate



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SLOW DOWN

Economy operates above the full employmentlevel of output but the rate of growthdecelerates and remains less than the peakgrowth rate achieved by the economy.

Slowdown is associated with the slowdown inthe rate of increase in the price level i.e. pricelevel increase in this phase but at a declining

rate. The decline in the rate of growth of overall price

level and inflation rate above the fullemployment level of output is known as

Disinflation



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RECESSION:

In this phase there is a contraction in economicactivities.

The actual growth rate is lower than the growthrate at the full employment level.

Prices start declining in absolute term and theeconomy achieves negative growth rate in

prices.

Absolute decline in prices below the fullemployment level of output is known as

Deflation.



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DEPRESSION:

The country faces a depression when therecession is widely felt in the economy i.e. notonly there is overall recession in the economy

but most of the sectors of the economy aregoing through the recessionary phase andrecessionary phases is prolonged for a very longperiod of time.

High Unemployment .

Government is not able to stimulate theeconomy by various policy changes.



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Price level declines in sharply in absoluteterms.

These phases can be broadly clubbed under twobroad categories: High growth phase and Lowgrowth phase.

The high growth phase consists ofrecovery andexpansion in growth rates whereas low growthphase corresponds to slowdown and recessionin the growth rates.



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USEFULNESS:

Growth cycles have been found useful inunderstanding the relationship between output,

inflation and unemployment.

However trend estimation is an important stepin determination of cycles through deviations.

Growth cycles depend on an arbitrarydistinction between trend and cycle.



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In certain cases the same shock affects bothlong run growth and business cycle fluctuationswhich make segregation of the cyclicalcomponent from the trend component difficult.


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MONEY DEMAND ANDSUPPLY

MONEY AND MONEY SUPPLY


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MONEY:

Money is anything that is generally accepted as a mediumof exchange.

People take it for granted that they can walk into any

store, restaurant or boutique and buy whatever they wantas long as they have enough currency notes in theirpocket.

3 crucial functions of Money:

A.MEDIUM OF EXCHANGE

Money is exchanged for goods and services when peoplebuy things and goods orservices are exchanged for money

when people sell things.

O O SU



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No one ever has to trade goods for other goods directly.

B. STORE OF VALUE

Money also serves as a store of value that is an assetthat can be used to transport purchasing power from one

time period to another.

Money is advantageous to other medium like Gold, Silver,Diamond, antique paintings etc. in which value could bestored.

1. It comes in convenient denomination2. Can easily be exchanged for goods at all times.

Disadvantage: The value of money falls in inflationaryconditions hence it needs to be converted into some

valuable assets.



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C. A UNIT OF ACCOUNT: (All prices are quoted inmonetary units)

Money also serves as a unit of account, a consistentway ofquoting prices.

All prices are quoted in monetary units. Thus MONEY MAY BE DEFINED AS ANYTHING THAT IS

GENERALLY ACCEPTABLE AS A MEANS OF EXCHANGEAND AT THE SAME TIME CAN BE USED AS A MEASUREOF STORE OF VALUE.

The Government declares its paper money to be legaltenderand must be accepted in settlement of debts. Itdoes this by fiat and hence the term fiat money.



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MONEY SUPPLY:

Total Stock of Money available to society for use inconnection with the economic activity of the nation at apoint of time.

It comprises oftwo elements namely :

A. Currency with public (households, firms and institutionsother than banks and the Government).

Currency with the public is the sum total of the currencynotes in circulation issued by the RBI, no. of rupee notes

and coins in circulations and small coins in circulation

The Cash Reserves with banks must remain with themand hence have to be deducted from the above sum.

B. Demand deposits with the public.



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The demand deposits with the public are the bankdeposits held by the public.

Bank deposits are either demand deposits or timedeposits.

While demand deposits can be withdrawn by the publicby drawing cheques on them, time deposits mature onlyafter fixed period and are money that people hold as astore of value.

MEASURING MONEY SUPPLY:

Money Supply M1 :Narrow Measure of Money Supply

M1 = C +DD + OD [where C= Currency notes and coins with

the public; DD= Demand Deposits with all commercialand cooperative banks; OD= Other deposits with the

Central Bank]



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M1 is also known as transactions money. This is the

money that can be directly used for transactions, that is,to buy things.

Further, M1 is stock measure, that is, it is measured at apoint in time.

It is the total amount of currency notes and coinsoutside of banks and the total amount in demand

deposits on a specific day.

Since the money included in M1 can easily be used as a

medium of exchange it is the most liquid measure ofmoney supply.



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Money Supply M2:

Broader Concept of Money

M2 = M1 + SD

Where SD= Savings Deposits with post office savingsbanks.

SB with post offices are in between demand depositswith banks and time deposits with banks, with regard toliquidity.



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Money Supply M3:

M3 is broad concept of money supply.

It includes time deposits with banks in addition to themoney supply M1:

M3 = M1 + TD

Where TD is time deposits with all commercial and co-operative banks.

This measure uses time deposits because although time

deposits cannot be withdrawn through drawing chequeson them but loans from banks can easily be obtainedagainst such deposits.

Further, they can be withdrawn any time by foregoingsome interest earned on them.



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Of late M3 has become a popular measures of moneysupply.

MONEY SUPPLY M4:

This measure includes deposits with post office savings

organisation besides M3.

It is however excludes contributions made by public tothe National Savings Certificates.

Whatever may be the measure, Money Supply is

determined by four factors:

1. Bank Credit to Government2. Bank Credit to Private Sector3. Changes in net foreign exchange assets and4. Governments currency liabilities to public.

THE BANKING SYSTEM


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Most of the money today is bank money ofone type oranother.

Banks and other financial intermediaries borrow fromindividuals or firms having excess funds and lend tothose who need funds.

Banks and bank like institutions are called financialintermediaries because they mediate or act as a linkbetween people who have funds to lend and those whoneed to borrow.

Commercial banks, developmental finance institutions,non banking finance companies, savings and loanassociations, life insurance companies and pensionfunds are various categories of financial intermediaries.

THE BANKING SYSTEM


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ACCOUNTING INBANKS:

For a bank assets include the bank building, its furniture,its holdings of government securities, cash in the vaults,bonds, stocks and so on.

Most important among assets are loans. A borrowergives the bank an IOU a promise to repay

a certain sum of money on or by a certain date.

This promise is an assets of the bank because it isworth something.

The bank could and sometimes does sell the IOU toanother bank for cash.

THE BANKING SYSTEM


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Other bank assets include cash on hand and depositswith the central bank.

A firms liabilities are its debts or the amount it owes toany one, A banks liabilities are the promises to pay orIOUs that it has issued.

A banks most important liabilities are its deposits. Deposits are debts owed to the depositors because

when money is deposited in account we in essencemaking a loan to the bank.

Excess Reserves = Actual Reserves - RequiredReserves.

THE BANKING SYSTEM


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If banks give loans up to the point where they can nolonger do so because of the reserve requirementrestriction, it means that banks give loans up to thepoint where their excess reserves are zero.

The basic rule of accounting says that if we add up afirms assets and then subtract the total amount it owesto all those who have lent it funds the difference is thefirms net worth.

Net worth represents the value of the firm to itsstockholders or owners.

Cash Reserve Ratios and Statutory Liquidity Ratios arethe two types of reserves ratios .

THE BANKING SYSTEM


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MONEY CREATION:

Banks usually can not give loans upto the point wherethey want to do because of the reserve requirementrestrictions.

A banks required amount of reserves is equal to therequired reserves ratio to the total deposits in the bank.

The difference between a banks actual reserves and itsrequired reserves is excess reserves.



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Whatever may be the measure used Money Supply is

determined by four factors namely:

1. Bank Credit to Government2. Bank credit to private sector3. Changes in Net foreign exchange assets and

4. Govts currency liabilities to public.

Because a wide variety of financial instruments bearsome resemblance to money, it has been advocated toinclude almost all of them as part of the money supply.

In recent years for example credit cards have come tobe used extensively in exchange .

One of the very broad definitions of money includes theamount of available credit cards as part of the money

supply.

CENTRAL BANK AND MONEYSUPPLY


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3 Tools are available to the Central Bank for controlling themoney supply

a. Changing the required reserve ratiob. Changing the discount rate and

c. Engaging in open market operations.

REQUIRED RESERVE RATIO:

The required reserve ratio establishes a link between the

reserves of the commercial banks and the deposits(money) that commercial banks are allowed to create.

Reserve requirement effectively determines how muchmoney is available with the bank to lend.

SUPPLY



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Since money supply is equal to the sum of depositsinside banks and the currency in circulation outsidebanks, reserves provide the leverage that the CentralBank needs to control the money supply.

SUPPLY



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Reserves are of2 types:

1. Cash Reserve Requirements ( CRR) and2. Statutory Liquidity Ratio ( SLR)

CRR is the percentage of total deposits of a bank that ithas to keep with the Central Bank in the form of cash.

Statutory Liquidity Requirement (SLR) refers to theportion of the total deposits of a bank it is required tokeep with itself in the form of specified liquid assets thatis cash plus approved government securities.

Decreases in the required reserve ratio allow the banksto have more deposits with the existing volume ofreserves.

As banks create more deposits by making loans, the

supply of money increases. And vice versa

SUPPLY


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Discount Rate:

Interest rate banks pay to the central banks toborrowing money is known as discount rate.

When banks increase their borrowing , the money supplyincreases.

Through discounting rates Central Bank can influencebank borrowing . The higher the discount rate, higher is

the cost of borrowing and the less borrowing banks willwant to do .

Central Banks use the discount rate to control themoney supply.

SUPPLY



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It does change the discount rate from time to time tokeep it in line with other interest rates viz. it raises thediscount rate and discourages banks from borrowingfrom it thus restricting the growth of reserves andultimately deposits.

SUPPLY



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OPEN MARKET OPERATIONS:

Most significant tool. It refers to buying and selling of government securities

by the Central Bank

When sells some of holdings of government securities tothe general public Central banks holding of suchsecurities will decrease .

Purchasers of securities pay for these securities bywriting cheques drawn on their banks and payable to the

Central Bank.

Thus the money supply would contract . Money supply could be increased by buying government

securities from people who own them .

SUPPLY



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Each day the open market desk at Central bank buys orsells government securities usually to large securitydealers who ct as intermediaries between the centralbank and the private markets.

SUPPLY



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An open market purchase of securities by the CentralBank results in an increase in reserves and an increasein the supply of money by an amount equal to the moneymultiplier times the change in reserves.

Similarly an open market sale of securities by theCentral Bank results in a decrease in reserves and adecrease in the supply of money by an amount equal tothe money multiplier times the change in reserves.

Open market operations are the Central Banks preferredmeans of controlling the money supply for severalreasons:

Central Bank needs to change the money supply by justa small amount, it can buy or sell a small volume of

government securities.

SUPPLY

SUPPLY CURVE FOR MONEY


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Open market operations are extremely flexible. If theCentral Bank decides to reverse the course it can easilyswitch from buying securities to selling .

Finally open market operations have a fairly predictableeffect on the supply of money.

A Vertical money supply curve signifies that the CentralBank sets the money supply independent of the interestrate.

Interest rate does not affect the RBIs decision on howmuch money to supply.

SUPPLY CURVE FOR MONEY


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Interest Rate r

Money M

Sm

DEMAND CURVE FOR MONEY


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Interest rate and the level of National Income influencehow much money households and firms wish to hold.

Demand depends on how much of the financial assetsthe household or the firm wants to hold in the form ofmoney that does not earn interest versus how much it

wants to hold in interest bearing securities such asbonds .

Motives behind demand for money:

Transaction Motive: The decision to hold money involves a trade off between

the liquidity of money and the interest income offered byother kinds of assets.



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Holding Money without interest is useful for dailytransactions by households.



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The precautionary motive:

Households and firms may hold money more than whatthey require for their current transactions consideringuncertainty of future receipts and expenditure as aprecaution.

It varies with income and is inversely related to theinterest rate.

The Speculative Motive.

There are several theories to explain why the quantity ofmoney households desire to hold may rise when interestrates fall and fall when interest rates rise.

One involves household expectation and the relationshipof interest rates to bond values.



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When market interest rates fall , bond values rise andwhen market interest rates rise bond values fall.

Desire to hold money balances instead bonds:

If market interest rates are higher than normal they mayexpected to come down in the future.

If and when interest rates fall , the bonds that werebought when they were high will increase in value.

When Interest rates are high, the opportunity cost ofholding cash balances is high and there is speculationmotive for holding bonds in lieu of cash, a speculationthat interest rates will fall in the future.



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TOTAL DEMAND FOR MONEY:

The total quantity of money demanded in the economy isthe sum of the demand for demand deposits and cash byhouseholds and firms.

Firms as well as households can hold their assets ininterest earning form. For manage their assets just ahouseholds do keeping some in their chequeableaccounts and some in bonds.

A higher interest rate raises the opportunity cost ofmoney for firms as well as households and thus reducesthe demand for money.



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Interest Rate r

Money M

Dm

EQUILIBRIUM INTEREST RATE


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Money supply curve is a vertical line since it isindependent of interest rates in the economy.

For the objective central bank uses its 3 tools (ReserveRatio, discount rate and opern market operations)

At r* the quantity of money in circulation that is themoney supply equal to the quantity of money demanded.

At r1 the quantity of money demanded is Dm1 and thequantity of money supplied exceeds quantity of moneydemanded .

This means there is more money in circulation thanhouseholds and firms want to hold



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Firms and households therefore will attempt to reducetheir money holdings by buying bonds.

When demand for bonds Is high, those looking to borrowmoney by selling bonds will find that they can do so at a

lower interest rate.

If the interest rate is initially high enough to create anexcess supply of money the interest rate willimmediately fall , discouraging people from moving out of

money and into bonds.

At r2 quantity of money demanded (Dm 2 ) exceeds thesupply of money currency in circulation.



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The households and firms do not have enough money onhand to facilitate ordinary transaction.

They will try to adjust their holdings by shifting assetsout of bonds and into their bank accounts.

At the same time the continuous flow of new bondsbeing issued must also be absorbed.

The government and corporations can sell bonds in anenvironment where people are adjusting their assetholdings to shift out of bonds only by offering a highinterest rate to the people for money , the interest ratewill immediately rise discouraging people from movingout of bonds and into money.

MONEY SUPPLY AND INTERESTRATES


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Central bank can affect the interest rates. It can reduce the interest rates by expanding the moneysupply ( Sm) .

To expand money the Central Bank can reduce thereserve requirement, cut the discount rate or buygovernment securities in the open market. All these practices expand the quantity of reserves inthe system.

Banks can grant more loans and the money supplyexpands the initial money supply curve and shifts it tothe right from Sm 0 to Sm 1 .

S



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At r0 there is an excess supply of money .Thisimmediately put pressure on the interest rates ashouseholds and firms try to buy bonds with their money

to earn that high interest rate.

As this happen the interest rate falls and it will continueto fall until it reaches the new equilibrium interest rate,r1.

At this point Sm 1 = Dm and the market is in equilibrium.



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If central bank wanted to drive the interest rate up , itwould contract the money supply. It could do so byincreasing the reserve requirement by raising discount

rate or by selling government securities in the openmarket.

The result would be lower reserves and a lower supply ofmoney.

Also Sm0 will shift to Sm 1 . lowers the interest rate fromr0 to r1.

MONEY DEMAND ANDINTEREST RATES


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The equilibrium interest rates can also be affected byshift in money demand.

The demand for money depends on both the interest rateand the volume of transactions.

We use the level of aggregate output (income) as arough measure of the volume of transactions.

The relationship between money demand and aggregateoutput (income), N is positive that is increases in N

means a higher level of real economic activity and viceversa.

More is being produced, income is higher and there aremore transactions in the economy.



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Consequently the demand for money on the part of firmsand households in aggregate is higher.

Thus an increase in N shifts the money demand curve toright.



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The result is an increase in the equilibrium level ofinterest rate from r0 to r1.

Money Demand Curve also shifts when the price levelchanges. If the price level rises, the money demand

curve shifts to the right because people need moremoney to engage in their day to day transactions.



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Interest Rate r

Money M

Dm

Sm

r1

Dm3m2m1

r*r2

E

INCREASE IN MONEY SUPPLY& INTEREST RATE


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Interest Rate r

Money M

Dm

r0

sm1m0

r1E0

E1

INCREASE IN MONEY SUPPLY& INTEREST RATE


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FISCAL AND MONETARY POLICIES

FISCAL POLICY


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Fiscal Policy is a tool , in the hands of a government toinfluence the level of GDP in the short run using taxesand government spending.

It is about bringing changes in taxes and spending so asto affect the demand for goods and services and hencethe output in the short run.

Total Spending of the Government :Total Spending = C + I+ G where

C- Autonomous consumption

I- InvestmentG- Government Purchases.

Any increase in the government purchase increases thetotal spending and hence the shift in line presenting C+

I+ G upwards

FISCAL POLICY


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Multiplier for Government spending = 1/ (1- MPC)

An increase in the government spending raises GDP (

Income).

The increase in income generates further increase indemand as consumers increase their spending

The government programs affect the disposable personal

income of the households.

The consumption spending depends on income aftertaxes and transfers or N T where T are the net taxes.

FISCAL POLICY


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Multiplier for Government spending = 1/ (1- MPC)

An increase in the government spending raises GDP (

Income).

The increase in income generates further increase indemand as consumers increase their spending

The government programs affect the disposable personal

income of the households.

The consumption spending depends on income aftertaxes and transfers or N T where T are the net taxes.

FISCAL POLICY


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The consumption faction with taxes is

C= C0 + b (N T)

As the level of taxes increases , the demand line willshift downward by b ( the increase in taxes) and theequilibrium income will fall from N0 to N2

Demand line does not shift by the same amount withtaxes as it does with government spending, the formulafor tax multiplier is slightly different:

Tax Multiplier = - b /(1-b)

FISCAL POLICY


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The tax multiplier is negative because increases in taxes

decrease disposable income and lead to a reduction inconsumption spending.

The multiplier for Government spending is larger than themultiplier for taxes.

Equal increases both in taxes and governmentexpenditure will increase GDP

The multiplier for equal increases in governmentspending and taxes is also known as the balanced

budget multiplier because equal changes in governmentspending and taxes will not unbalance the budget.

When the govt. increases its cuts its spending or cuttaxes to stimulate the economy it will increase the

governments budget deficit.

FISCAL POLICY


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Fiscal policy is a very important tool of macroeconomic

policy to stabilise the economy i.e. to overcomerecession and to control inflation.

EXPANSIONARY FISCAL POLICY:

Any Expansionary fiscal policy is an increase ingovernment spending (G) or a reduction in net taxes (T)aimed at increasing aggregate output (income) (N) .

Government purchases and net taxes are the tow toolsof a government fiscal policy.

Government can stimulate the economy i.e. it canincrease aggregate output (income) either by increasinggovernment purchases or by reducing net taxes.

FISCAL POLICY


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An increase in expenditure causes firms inventories tobe smaller than planned, unplanned inventory reductionsstimulates production and firms increase output.

FISCAL POLICY


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However because added output means added income ,some of which is subsequently spent consumptionspending also increases .

Again inventories will be smaller than planned andoutput will rise even further . The final equilibrium levelof output is higher by a multiple of the initial increase ingovernment purchases.

Effects of an expansionary fiscal policy:

G or T N Dm r I

FISCAL POLICY


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CONTRACTIONARY FISCAL POLICY:

Any government policy that is aimed at reducingaggregate output ( Income) is said to be contractionary. It is used for controlling inflation because a decrease inaggregate spending will bring down the rising prices.

A contractionary fiscal policy is a decrease ingovernment spending (G) or an increase in net taxes (T)aimed at decreasing aggregate output (income) (N) .

G or T N Dm r I

------ finer aspects to be mentioned

MONETARY POLICY


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Monetary policy:

It is a tool that incorporates the actions that the CentralBank takes to influence the level of GDP.

Central Bank can influence the level of output in theshort run through open market operations, changes inreserve requirements or changes in the discount rate.

These tools can be used to form a suitable monetarypolicy in the times of both recession as well as inflation.

The aggregate demand can be raised in recession periodby adopting an expansionary or easy monetary policywhile it can be reduced to control inflation through acontractionary or tight monetary policy.

MONETARY POLICY


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EXPANSIONARY MONETARY POLICY:

An expansionary monetary policy is an increase in themoney supply aimed at increasing aggregate output(income) N.

Using an expansionary monetary policy when the centralbank decides to increase the supply of money, theincrease in the quantity of money supplied pushes downthe interest rate.

Lower Interest rate causes planned investment spendingto rise.

The increased planned investment spending meanshigher planned aggregate expenditure which in turnmeans increased output as firms react to unplanned

decreases in inventories.

MONETARY POLICY


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This increase in output (income) leads to an increase inthe demand for money and the money demand curveshifts to the right.

This means that interest rate decreases less than itwould have if the demand for money had not increased.

The entire sequence of events depicting the effects of anexpansionary monetary policy can be summed us asfollows:

M s r I N

MONETARY POLICY


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CONTRACTIONARY MONETARY POLICY:

Contractionary monetary policy leads to a decrease inthe money supply aimed at decreasing the aggregateoutput ( income) .

Using such policy when Central bank decreases themoney supply through either open market sale ofgovernment securities, increasing the required reserveratio or increasing the discount rate, the interest rate inthe economy also rises.

Since the level of planned investment spending is anegative function of the interest the higher the interestrate the lower the planned investment.

MONETARY POLICY


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The lower planned investment means a lower plannedaggregate expenditure and hence a lower equilibriumlevel of output (income) .

The lower equilibrium income results in a decrease inthe demand for money which means that the increase inthe interest rate will be less than it would be if we didnot take the goods market into account.

Ms r I N

AGGR.DEMAND & AGGR. SUPPLYFOR MONETARY AND FISCAL

POLICIES


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The effects of aggregate supply/aggr. Demand (AS/AD)framework can be effectively used to consider theeffects of monetary and fiscal policy.

The effects however will be different in short run andlong run.

SHORT RUN IMPACTS:

While an expansionary policy shifts the AD curve to the

right, a contractionary policy shifts it to the left.

The impact of policy change will depend on where alongthe short run AS curve the economy is at the time of thechange.

POLICIES

AGGR.DEMAND & AGGR. SUPPLYFOR MONETARY AND FISCAL

POLICIES


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If the economy is initially on the flat portion of the AScurve, (PointA) then an expansionary policy which shiftsthe AD curve to the right results in a small price increaserelative to the output increase.

POLICIES

AGGR.DEMAND & AGGR.SUPPLY FOR MONETARY AND


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The increase in in equilibrium output ( from N o to N1 ) ismuch greater than the increase in equilibrium price level( from P0 to P1) . This is the case in which anexpansionary policy works well.

There is an increase in output with little increase in theprice level.

If the economy is initially on the steep portion of the AScurve , then expansionary policy results in a smallincrease in equilibrium output ( from N0 to N1) and alarge increase in the equilibrium price level ( from P0 toP1)

FISCAL POLICIES



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In this case an expansionary policy does not workwellgher price level with little increase in output.

Igt results in a much h The multiplier effect is therefore close to zerio. Output initially close to capacity and any attempt to

increase it further leads mostly to the higher price level.

FISCAL POLICIES



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Thus it is important to know where the economy is beforea policy change is put into effect.

The economy is producing on the nearly flat part of theAS curve if most firms are producing well below capacity. When this is the case, firms will respond to an increase indemand by increasing output much more than theyincrease prices.

If the economy is producing on the steep part of the AScurve, firms are close to capacity and will respond to anincrease in demand by increasing prices much more thanthey increase output.

FISCAL POLICIES



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LONG RUN EFFECTS:

In the long run since the AS curve is vertical so neithermonetary policy nor fiscal policy has any affect onaggregate output in the long run.

FISCAL POLICIES



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The monetary and fiscal policies shift the AD curve . Ifthe long run AS curve is vertical output always comesback to N0 . In this case policy affects only the pricelevel.

The multiplier effect of a change in government spendingon aggregate output in the long run is zero.

Similarly the tax multiplier is also zero.

FISCAL POLICIES

STABILISATION POLICY


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The Government can use either fiscal policy or monetarypolicy to alter the level of GDP.

If the Current level of GDP is below full employment orpotential output the government can use expansionarypolicies such as tax cuts, increased spending or

increase in money supply to raise the level of GDP andreduce unemployment.

If the current rate of GDP exceeds full employment orpotential output the rate of inflation will increase.

To avoid this the government can use contractionarypolicies to reduce the level of GDP back to fullemployment or potential output.



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STABLISATION POLICIES ARE A SET OF ACTIONS THATREDUCE THE LEVEL OF GDP BACK TO FULL POTENTIAL

OUTPUT.

In practical difficult to stabilise the level of aggregateoutput because of lags or delays in stabilisation policy. Lags arise because decision makers are often slow torecognise and respond to changes in the economy andmonetary/fiscal policies take time to operate:.



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LAGS:

Poorly timed policies can magnify economy fluctuations

If GDP was currently below full employment but wouldreturn to full employment on its own within one year andthat stabilisation policies took a full year to becomeeffective.

If policy makers tried to expand the economy today ,their actions would not take effect until a year from now.

BUT ONE YEAR FROM NOW IF STABILISATION POLICIESWERE ENACTED THE ECONOMY WOULD BE STIMULATEDUNNECESSARILY AND OUTPUT WOULD EXCEED FULLEMPLOYMENT.

LAGS


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INSIDE LAGS:

They occur for two basic reasons: 1. It takes time to identify and recognise a problem

( Data may indicate confusing picture some economicindicators may look fine , others may appear worrisome.So how to diagnose the problem.

It often takes from several months to a year before it isclear that there is a serious problem with the economy.

Further for inside lags once a problem has beendiagnosed it still takes time before any action can betaken.

LAGS


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OUTSIDE LAGS:

Both Monetary and fiscal policies are subject to outsidelags, the time it takes for policy to be effective.

Central Bank can increase the money supply to rapidly

lower the interest rate but firms must change theirinvestment plans before monetary policy can beeffective.

In case of Fiscal Policy, if taxes are cut, individuals andbusinesses must change their spending plans to takeadvantage of cut; it will take some time before anyaffects of the tax cuts will be felt in the economy.

POLICY MIX


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POLICY MIX:

Policy Mix refers to the combination of monetary andfiscal policies in use at a given time.

Monetary and Fiscal policy both should be usedsimultaneously.

For Example: both government purchases and moneysupply can be increased at the same time.

While the increase in government purchases raises bothN and r , and increase in money supply raises N butlowers r.

Hence if the govt wanted to increase N without changingr it could do so by increased supply by the appropriate

amounts

POLICY MIX


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asing both govt. purchases and m A Policy mix that consists of a decrease in govt spendingand an increase in money supply would favourinvestment spending over government spending.

This is because both the increased money supply and thefall in government purchases would cause the interestrate to fall which would lead to an increase in plannedinvestment.

The opposite is true for a mix that consists of anexpansionary fiscal policy and a contractionarymonetary policy.

Tight money and expanded government spending woulddrive the interest rate up and planned investment down.


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FISCAL POLICY EFFECT


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C + I + G 0

Demand


TotalSp

ending=

Output

EC + I + G 1

N 0 N 1


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FISCAL POLICY EFFECT


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C + I + G 2

Demand


TotalSp

ending=

Output

Aggregate Demand[ EFFECT IVEDEMAND ] =Aggregate Supply

EEffectiveDemand

C + I + G 0

N 1 N 0

CROWDING OUT EFFECT


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1 C + I 0 + G o (for r = r 0 )

Planned

aggregate

Expdt.

Aggr. Output (Income) N

TotalSp

ending=

Output

EEffectiveDemand

3 C + I 1 + G 1 (for r = r1 )

N*0 N 1

2 C + I 0 + G 0 (for r = r0 )

EXPANSIONARY MONETARYPOLICY


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Planned

aggregate

Expdt.

Aggr. Output (Income) N

TotalSp

ending=

Output

E C + I 0 + G + X

N*0 N 1

C + I 1 + G + X

I

N

EXPANSIONARY MONETARYPOLICY


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INTERESTRATE, rINTERESTRATE, r

MONEY INVESTMENT0 I1

IDm

a


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EXPANSIONARY MONETARYPOLICY (AD & AS)


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LASPrice Level,P

Aggr.Output(Income),N

AS1

P1Po

No N1AD0

AS0

AD1

P2

TYPES OF PRICE INDICES


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INFLATION



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TYPES OF PRICE INDEX:

CONSUMER PRICE INDEX: movements in theconsumer prices orretail prices are captured inCPI.

This measures the cost of living in a givencountry.



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CPI is the most relevant price index for the

consumers as it measures the cost of thebasket of only those goods and services whichare directly purchased by them in a given periodof time relative to the cost of the same basketof goods and services in same specified period

known as the base year.



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Identification of the basket of goods:

The basket usually covers the items ofconsumption in day to day life such as food,clothing, housing, fuel, transport, education,medicine, electricity, telephone, entertainment.

Determination of the weights for each of thecommodity covered in the consumption basket.

This involves identifying the share ofexpenditure on each item in the basket in thetotal expenditure on the basket of commodities.



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Regular monitoring of the prices: Prices ofthe products covered in the consumption basket need

to be collected on a regular basis through household

surveys.

Determination of base year:

The year set as the base year has to be anormal year.


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CPI is based on retail prices, whereas PPI isestimated on the basis of producers prices

which exclude taxes, trade margins andtransportation costs.

Thus the ratio between the CPI and the PPIindicagtes the extent of distribution cost fallingon the consumers.

It also differs from CPI in terms of coverageand composition as PPI includes raw materialsand semi finishbed goods.



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PPI serves as one of the leading indicator ofbusiness cycle that is closely watched by thepolicy makers, business managers and even theinvestors in share and forex markets.


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In many countries the distrinction is not madebetween PPI and WPI and PPI is treated as WPI.

Many of the countries which have beencompiling WPI and PPI from WPI because PPI isconsidered to be a better measure of inflationas price changes at primary and intermediatestages can be tracked before it gets built into

the finished good stage.


GDP DEFLATOR:


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The price which reveals the cost of purchasingthe items included in GDP during the periodrelative to the cost of purchasing those sameitems during a base year is termed as GDPdeflator or implict price index.

GDP Deflators = Nominal GDP /Real GDP= GDP at current prices in the

current year/GDP at constant price in the

current year.

GDP measures the output produced in thedomestic territory, GDP deflator ignores theprices of imported goods.



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The base year chosen is assigned the value 100Hence GDP deflator takes on value greater than100, it indicates the prices have risen



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The ratio of nominal GDP to real GDP is termedas a deflator because one can divide ( ordeflate) nominal GDP by this ratio to correct forthe effect of inflation on GDP, i.e.

Real GDP = Nominal GDP /GDP Deflator Thus the GDP deflator can be used to measure

real GDP i.e. GDP in rupees of constantpurchasing power.



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GDP deflator is also known as the implicit priceindex because GDP deflator implies a priceindex not estimated directly but implicitylyemerging in the process of estimating real andnorminal GDP.

GDP deflator is athe most comprhensivemeasure encompassing the entire spect

part i 1 introduction macro economic 512011

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