Introduction to

Macroeconomics
 Leaning Objectives?

This chapter introduces you to

• What is Macroeconomics
• the issues macroeconomists
study
• the tools macroeconomists use
• some important concepts in
macroeconomic analysis
 What is
Macroeconomics?

• Macroeconomics is the study of the

structure and performance of
economy as a whole and of the
policies that governments use to
influence the economic
performance.

• it examines the behavior of

economic aggregates such as
aggregate income, consumption,
investment, and the overall level of
prices.
What Macroeconomists Study

Why are some countries rich and others poor?

Why have some countries’ incomes grown rapidly over the

past decade while others have stagnated?

Why do some countries have high rates of inflation while

others maintain stable prices?

Why do all countries experience periods of economic

stagnation or even crisis?
 What can government policy do to help
an economy recover from a slump?

How do we know whether the amount

of money that has been printed is too
What much, too little, or just enough?
Macroeconomists
Should India keep the value of Rupee
Study fixed with respect to the US dollar?

Why has India been running huge trade

deficits (CAD)? Does it matter?
Macroeconomics

• Macroeconomists collect data on incomes, price

levels, interest rates, unemployment, and many
other macroeconomic variables from different time
periods and different countries

• They then try to build general theories to explain

the data that history gives them
Microeconomics Vs
Macroeconomics

Microeconomics Examines the functioning

of individual industries and the behavior of
individual decision-making units—firms and
households.
Macroeconomics Deals with the economy as a
whole. Macroeconomics focuses on the
determinants of total national income, deals
with aggregates such as aggregate
consumption and investment, and looks at the
overall level of prices instead of individual
prices.
TABLE: Examples of Microeconomic and Macroeconomic Concerns

Div isions
of Economics Production Prices Income Employment

Microeconomics Production/output in individual Price of individual Distribution of Employment by

industries and businesses goods and services income and individual businesses
wealth and industries
How much steel
How much office Price of medical care Wages in the auto Jobs in the steel
space Price of gasoline industry industry
How many cars Food prices Minimum wage Number of employees
Apartment rents Executive salaries in a firm
Poverty Number of
accountants

Macroeconomics National production/output Aggregate price level National income Employment and
unemployment in
the economy
Total industrial output
Gross domestic Consumer prices Total wages and Total number of jobs
product Producer prices salaries Unemployment rate
Growth of output Rate of inflation Total corporate
profits
Macroeconomics: interconnections

First, macroeconomics is where we learn how to think about

the economy as a collection of multiple markets that affect,
and are affected by, each other.

It is not enough to analyze the goods market, and

then the asset market, and then the labor market,
and so on; all markets must be analyzed together,
as interacting arenas of economic activity.
 Macroeconomics is where we can
learn to think dynamically about
the economy.

It is important to understand how

Macroeconomics: today leads to tomorrow, how
dynamics tomorrow leads to the day after,
and so on.
This emphasis on the dynamic laws
of motion of an economy also
makes macroeconomics different.
 Macroeconomic Concerns

Three of the major concerns

of macroeconomics are

• Output growth

• Unemployment

• Inflation and deflation

 Macroeconomic Concerns
- Output Growth

• business cycle The cycle of short-term

ups and downs in the economy.

• aggregate output The total quantity of

goods and services produced in an
economy in a given period.

• recession A period during which aggregate

output declines. Conventionally, a period
in which aggregate output declines for two
consecutive quarters.
Macroeconomic Concerns - Output
Growth

• expansion or boom The period in the

business cycle from a trough up to a peak
during which output and employment grow.

• contraction, recession, or slump The

period in the business cycle from a peak down
to a trough during which output and
employment fall.
 Recessions

• Recession is the downward phase of a business

cycle when national output is falling or growing
slowly.
• Hard times for many people
• A major political concern
• A prolonged and deep recession becomes a
depression.
• Policy makers attempt not only to smooth
fluctuations in output during a business cycle
but also to increase the growth rate of output
in the long-run.
The Historical Performance of the U.S. Economy:
The Historical Performance of the Indian.
Economy:
 Measuring Fluctuations
• In order to claim a recession is big or
small, an unemployment rate is too high
or too low, one needs to have a standard
to measure against.

• The “normal” or “trend” or “potential”

or “full employment” output is the
standard to compare expansions or
recessions.
 Output Gap

• If the economy produces less than its

potential amount, the “negative output
gap” will also be responsible for slow
growth and recession.
• If the economy produces more than its
potential amount because labor and/or
capital is overworked, the “Positive
output gap” will be responsible for fast
growth.
• Output gap: Y - Y* . Actual GDP–
Potential GDP
Unemployment

• Recessions are usually

accompanied by high
unemployment: the
number of people who are
available for work and are
actively seeking it but
cannot find jobs.

Unemployed
Unemployme nt Rate =  100%
Labour Force
The Historical Performance of the U.S. Economy
 Okun’s Law

• Arthur Okun in the sixties observed that

every time unemployment rate in the US
rose one percentage point above the
natural rate, GDP fell 3 percentage points
below the potential GDP.

• Recent data indicate that the relationship is

now one percent deviation of
unemployment rate implies two percentage
point deviation in GDP.
 Inflation

• When prices of most goods

and services are rising over
time it is inflation. When they
are falling it is deflation.
• The inflation rate is the
percentage increase in the
average level of prices.
 Effects of Inflation

• When the inflation rate

reaches an extremely high
level the economy tends
to function poorly. The
purchasing power of
money erodes quickly,
which forces people to
spend their money as
soon as they receive it.
The International Economy

• An economy which has extensive trading

and financial relationships with other
national economies is an open economy. An
economy with no relationships is a closed
economy.
The International
Economy (continued)

• International trade
and borrowing
relationships can
transmit business
cycles from country
to country.
 Trade Imbalances

• Trade imbalances (trade

surplus and deficit) affect
output and employment.
• Trade surplus: exports
exceed imports.
• Trade deficit: imports
exceed exports.
 The Exchange Rate

• The trade balance is

affected by the exchange
rate: the value of
domestic currency in
terms of a foreign
currency. It explains the
amount of domestic
currency required to
purchase one unit of
foreign currency (Amount
of INR required to
purchase one USD/ GBP/
EUR).
 The Components of the
Macroeconomy

• Households receive income from firms and the

government, purchase goods and services from
firms, and pay taxes to the government. They
also purchase foreign-made goods and services
(imports). Firms receive payments from
households and the government for goods and
services; they pay wages, dividends, interest,
and rents to households and taxes to the
government. The government receives taxes
from firms and households, pays firms and
households for goods and services—including
wages to government workers—and pays interest
and transfers to households. Finally, people in
other countries purchase goods and services
produced domestically (exports).
The Components of the Macroeconomy
The Three Market Arenas

Another way of looking at the ways

households, firms, the government, and the
rest of the world relate to each other is to
consider the markets in which they interact.

We divide the markets into three broad

arenas:

(1) the goods-and-services market,

(2) the labor market, and

(3) the money (financial) market.

 Macroeconomic Policy

• A nation’s economic
performance depends on:
• natural and human
resources;
• capital stock;
• technology
• economic choices made by
citizens;
• macroeconomic policies of
the government.
 Macroeconomic Policy

fiscal policy Government policies

concerning taxes and spending.

Monetary policy The

tools used by the Central
Bank to control the
quantity of money,
which in turn affects
interest rates.
Macroeconomic Policy
National Income
Accounting
Macroeconomics

▪ Macroeconomics answers
questions like the following:
Why is average income high in some
countries and low in others?
Why do prices rise rapidly in some time
periods while they are more stable in
others?
Why do production and employment
expand in some years and contract in
others?
The Economy’s
Income and Expenditure
When judging whether the economy is doing well
or poorly, it is natural to look at the total income
that everyone in the economy is earning.
The Economy’s
Income and Expenditure
▪ For an economy as a
whole, income must equal
expenditure because:
Every transaction has a
buyer and a seller.
Every dollar of spending
by some buyer is a dollar
of income for some
seller.
 Gross Domestic Product
▪ Gross domestic product (GDP) is a measure of the
income and expenditures of an economy.
The Circular-Flow Diagram
The equality of income and
expenditure can be illustrated with
the circular-flow diagram.
The Circular Flow

7
The Measurement of GDP
GDP is the market value of all final
goods and services produced within
a country in a given period of time.
The Measurement of GDP
▪ Output is valued at market
prices.
▪ It records only the value of
final goods, not intermediate
goods (the value is counted
only once).
▪ It includes both tangible
goods (food, clothing, cars)
and intangible services
(haircuts, housecleaning,
doctor visits).
 GDP = (Price of apples  Quantity of apples)
+ (Price of oranges  Quantity of oranges)
= ($0.50  4) + ($1.00  3) GDP = $5.00

2) Used goods are not included in the calculation of GDP.

3) The treatment of inventories depends on if the goods are stored or
if they spoil. If the goods are stored, their value is included in GDP.
If they spoil, GDP remains unchanged. When the goods are finally
sold out of inventory, they are considered used goods (and are not
counted). 10
The Measurement of GDP

▪ It includes goods and services currently produced, not

transactions involving goods produced in the past.
▪ It measures the value of production within the
geographic confines of a country.
What Is Counted in GDP?

GDP includes all items

produced in the economy and
sold legally in markets.
What Is Not Counted in GDP?
▪ GDP excludes most items that are produced and
consumed at home and that never enter the
marketplace.
▪ It excludes items produced and sold illicitly, such
as illegal drugs.
 More Rules for Computing GDP

Intermediate goods are not counted in GDP– only the value of final
goods. Reason: the value of intermediate goods is already included in
the market price. Value added of a firm equals the value of the firm’s
output less the value of the intermediate goods the firm purchases.

Some goods are not sold in the marketplace and therefore don’t have
market prices. We must use their imputed value as an estimate of
their value. For example, home ownership and government services.

14
Value added

The value of output minus the value of the

intermediate goods used to produce that output

15
NOW YOU TRY:
Identifying value-added
▪ A farmer grows a bushel of wheat
and sells it to a miller for $1.00.
▪ The miller turns the wheat into flour
and sells it to a baker for $3.00.
▪ The baker uses the flour to make a loaf of
bread and sells it to an engineer for $6.00.
▪ The engineer eats the bread.
Compute value added at each stage
of production and GDP
17
Other Measures of Income
▪ Gross National Product
(GNP)
▪ Net National Product
(NNP)
▪ National Income
▪ Personal Income
▪ Disposable Personal
Income
Gross National Product

▪ Gross national product

(GNP) is the total
income earned by a
nation’s permanent
residents (called
nationals).
▪ It differs from GDP by
including income that
our citizens earn abroad
and excluding income
that foreigners earn here.
 GNP vs. GDP
▪ Gross National Product (GNP):
Total income earned by the nation’s factors of production,
regardless of where located
▪ Gross Domestic Product (GDP):
Total income earned by domestically-located factors of production,
regardless of nationality
GNP – GDP = factor payments from abroad
minus factor payments to abroad

▪ Examples of factor payments: wages, profits, rent, interest &

dividends on assets

20
NOW YOU TRY:
Discussion Question

In your country, which would you want to be bigger,

GDP or GNP? Why?
 Net National Product (NNP)
▪ Net National Product
(NNP) is the total
income of the nation’s
residents (GNP) minus
losses from
depreciation.
▪ Depreciation is the wear
and tear on the
economy’s stock of
equipment and
structures.
 National Income

▪ National Income is the

total income earned by a
nation’s residents in the
production of goods and
services.
▪ It differs from NNP by
excluding indirect
business taxes (such as
sales taxes) and including
business subsidies.
 Personal Income
▪ Personal income is the income
that households and
noncorporate businesses receive.
▪ Unlike national income, it
excludes retained earnings,
which is income that
corporations have earned but
have not paid out to their
owners.
▪ In addition, it includes
household’s interest income and
government transfers.
Disposable Personal Income

▪ Disposable personal income is the income that

household and noncorporate businesses have left after
satisfying all their obligations to the government.
▪ It equals personal income minus personal taxes.
 Components of Expenditure

Y = C + I + G + NX

Total demand Investment

for domestic is composed spending by
output (GDP) of businesses and
households Net exports
or net foreign
Consumption Government demand
spending by purchases of goods
households and services

This is the called the national income accounts identity.

26
The Components of GDP

▪ Consumption (C):
The spending by households
on goods and services, with
the exception of purchases
of new housing.
▪ Investment (I):
The spending on capital
equipment, inventories,
and structures, including
new housing.
 The Components of GDP
▪ Government Purchases (G):
The spending on goods
and services by local,
state, and federal
governments.
Does not include transfer
payments because they
are not made in exchange
for currently produced
goods or services.
▪ Net Exports (NX):
Exports minus imports.
 Real vs. Nominal GDP
The value of final goods and services measured at current prices is
called nominal GDP. It can change over time either because there is a
change in the amount (real value) of goods and services or a change in
the prices of those goods and services.

Hence, nominal GDP Y = P  y, where P is the price level and y is real

output– and remember we use output and GDP interchangeably.

Real GDP or, y = YP is the value of goods and services measured
using a constant set of prices.

29
Real GDP controls for inflation
▪ Changes in nominal GDP can be due to:
▪ changes in prices.
▪ changes in quantities of output produced.
▪ Changes in real GDP can only be due to changes in
quantities,
**One way to construct real GDP is by using
constant base-year prices.

30
Real vs. nominal GDP

n
GDPt =  Pit Qit
i=1
n
RGDPt =  PiBQit
i=1

31
NOW YOU TRY:
Real & Nominal GDP

2006 2007 2008

P Q P Q P Q

good A $30 900 $31 1,000 $36 1,050

good B $100 192 $102 200 $100 205

▪ Compute nominal GDP in each year.

▪ Compute real GDP in each year using 2006 as the
base year.
NOW YOU TRY:
Answers
nominal GDP multiply Ps & Qs from same year
2006: $46,200 = $30 × 900 + $100 × 192
2007: $51,400
2008: $58,300

real GDP multiply each year’s Qs by 2006 Ps

2006: $46,200
2007: $50,000
2008: $52,000 = $30 × 1050 + $100 × 205
GDP Deflator

▪ Inflation rate: the percentage increase in the

overall level of prices
▪ One measure of the price level: GDP deflator
Definition:

35
NOW YOU TRY:
GDP deflator and inflation rate
GDP Inflation
Nom. GDP Real GDP
deflator rate

2006 $46,200 $46,200 n.a.

2007 51,400 50,000

2008 58,300 52,000

▪ Use your previous answers to compute
the GDP deflator in each year.
▪ Use GDP deflator to compute the inflation rate
from 2006 to 2007, and from 2007 to 2008.
NOW YOU TRY:
Answers
Nominal GDP Inflation
Real GDP
GDP deflator rate

2006 $46,200 $46,200 100.0 n.a.

2007 51,400 50,000 102.8 2.8%

2008 58,300 52,000 112.1 9.3%

GDP and Economic Well-Being

▪ GDP is the best

single measure of
the economic well-
being of a society.
▪ GDP per person
tells us the income
and expenditure of
the average person
in the economy.
 GDP and Economic Well-Being
▪ Higher GDP per
person indicates a
higher standard of
living.
▪ GDP is not a perfect
measure of the
happiness or quality
of life, however.
 GDP and Economic Well-Being
Some things that contribute to
well-being are not included in
GDP.
✓ The value of leisure.

✓ The value of a clean

environment.
✓ The value of almost all
activity that takes place
outside of markets, such as the
value of the time parents
spend with their children and
the value of volunteer work.
 Limitations of the GDP Concept
The Underground Economy
underground
economy The part
of the economy in
which transactions
take place and in
which income is
generated that is
unreported and
therefore not counted
in GDP.
 Summary
▪ Because every transaction has a buyer and a seller, the
total expenditure in the economy must equal the total
income in the economy.
▪ Gross Domestic Product (GDP) measures an
economy’s total expenditure on newly produced
goods and services and the total income earned from
the production of these goods and services.
Summary
▪ GDP is the market value of all final goods and
services produced within a country in a given
period of time.
▪ GDP is divided among four components of
expenditure: consumption, investment,
government purchases, and net exports.
Summary

▪ Nominal GDP uses current prices to value

the economy’s production. Real GDP uses
constant base-year prices to value the
economy’s production of goods and
services.
▪ The GDP deflator--calculated from the ratio
of nominal to real GDP--measures the level
of prices in the economy.
Summary
▪ GDP is a good measure of economic
well-being because people prefer
higher to lower incomes.
▪ It is not a perfect measure of well-being
because some things, such as leisure
time and a clean environment, aren’t
measured by GDP.
Demand for Money
Money: Definition
Money is the stock
of assets that can be readily used to make
transactions.

2
Money Defined:
▪ What Is Money?
▪ Assets widely used and
accepted as a means of
payment.

▪ Money is very liquid, but

pays little or no return.
▪ All other assets are
less liquid but pay
higher return.
 Money: Functions
▪ medium of exchange
we use it to buy stuff
▪ store of value
transfers purchasing
power from the present
to the future
▪ unit of account
the common unit by
which everyone
measures prices and
4
values
Money: Classifications
1. Fiat money
▪ has no intrinsic
value
▪ example: the
paper currency we
use
2. Commodity money
▪ has intrinsic value
▪ examples:
gold coins,
cigarettes in
P.O.W. camps 5
The central bank
▪ Monetary policy is
conducted by a
country’s central
bank.

▪ In India.,
the central bank
is called the
Reserve Bank of
India (RBI).

6
Demand for Money

Assumption:
Demand for money is a
demand for real
balances: people hold
money for its
purchasing power; for
the amount of goods
they can buy with it; not
concerned with the
nominal money
holdings; i.e. the
amount of paper
currency they hold
7
 Demand for Money
▪ It implies two things:
▪ Real money demand is
unchanged when the price level
increases and all real variables,
such as interest rate, real income
and real wealth remain
unchanged.
▪ Equivalently nominal money
demand increases in proportion
to the increase in the price level,
given the real variables just
mentioned above.
▪ This implies that an individual is free
of money illusion i.e. his real
behaviour is not being affected by a
change in price level, if all other real
variables remain constant. 8
 The Quantity Theory of Money

▪ A simple theory linking

demand for money with
income
▪ It states that demand
for money is a function
of prices and income,
as long as its velocity is
constant.
▪ What is the concept of
velocity?
Velocity
▪ basic concept: the rate at
which money circulates
▪ definition: the number of
times the average dollar bill
changes hands in a given
time period
▪ example: In 2007,
▪ $500 billion in
transactions
▪ money supply = $100
billion
▪ The average dollar is
used in five transactions
in 2007
▪ So, velocity = 5
10
 Velocity, cont.
▪ This suggests the
following definition:

where
V = velocity
T = value of all
transactions
M = money supply 11
 Velocity, cont.
▪ Use nominal GDP as a proxy for total
transactions.
Then,
where
P = price of output (GDP deflator)
Y = quantity of output (real GDP)
P ×Y = value of output (nominal GDP)

12
Nominal GDP Vs Value of transactions
Nominal GDP includes the
value of purchases of final
goods; total transactions also
includes the value of
intermediate goods.

Even though they are different,

they are highly correlated.
Also, our models focus on
GDP, and there’s lots of
reliable data available on GDP.
Therefore mostly in studies,
the income version of velocity
is generally used. 13
 The quantity equation
▪ The quantity equation
MxV=PxY
follows from the preceding
definition of velocity.

▪ It is an identity:
it holds by definition of the
variables.
▪ This is the classical theory of
money demand. Classical
economists like Irving Fischer
believed that money demand
is a function of income
14
 The quantity theory of money, cont.
▪
The growth rate of a product
equals
the sum of the growth rates.
▪ The quantity equation in growth
rates:

15
The quantity theory of money, cont.

π (Greek letter “pi”)

denotes the inflation rate:

The result from the

preceding slide:

Solve this result

for : π

16
 The quantity theory of money, cont.

▪ Normal economic growth requires a certain amount of

money supply growth to facilitate the growth in transactions.
▪ Money growth in excess of this amount leads to inflation.

17
The quantity theory of money, cont.

∆Y/Y depends on growth in the factors of

production and on technological progress
(all of which we take as given, for now).

Hence, the Quantity Theory predicts

a one-for-one relation between
changes in the money growth rate and
changes in the inflation rate.
18
Confronting the quantity theory with
data
The quantity theory of
money implies:
1. Countries with higher
money growth rates
should have higher
inflation rates.
2. The long-run trend
behavior of a country’s
inflation should be
similar to the long-run
trend in the country’s
money growth rate.
Are the data consistent with
these implications? 20
International data on inflation and
money growth
Belarus
Indonesia
Turkey
Ecuador

Argentina

Singapore

Money supply growth

(percent, logarithmic scale)
Keynesion Theory of Money
Demand
▪ Demand for money
▪ varies directly with income and wealth
▪ varies indirectly with returns on alternative assets
(bonds and durable goods)
▪ Durable goods; poor substitue of money (not easy to
convert to liquidity) Hence returns are ignored
▪ According to Keynes; demand for money depends on
income or interest rates
The Demand for
Money by Individuals
▪ Three factors influence money demand:
▪ Expected return (Speculative Motive)
▪ Risk (Precautionary Motive)
▪ Liquidity (Transaction Motive)
▪ Expected Return
▪ The interest rate measures the opportunity cost
of holding money rather than interest-bearing
bonds.
▪ A rise in the interest rate raises the cost of
holding money and causes money demand to
fall.
The Demand for
Money by Individuals
▪ Precautionary
▪ Holding money is important.
▪ To meet an unexpected expense like medical
expenses.
▪ Thus, liquidity preference which exists for
unforeseen exigencies of life constitutes
precautionary motive.
The Demand for
Money by Individuals
▪ Transaction
▪ The main benefit of holding money comes from
its liquidity.
▪ Households and firms hold money because it is
the easiest way of financing their everyday
purchases.
▪ A rise in the average value of transactions
carried out by a household or firm causes its
demand for money to rise.
Money demand and
the nominal interest rate
▪ In the quantity theory of money,
the demand for real money balances
depends only on real income Y.
▪ Another determinant of money demand:
the nominal interest rate, i.
▪ the opportunity cost of holding money (instead of
bonds or other interest-earning assets).
▪ Hence, i   in money demand.
Keynes’s Liquidity Preference
Theory
Liquidity Preference (real money balances)
Md
= f (i , Y )
P − +

▪ Keynes concludes that the demand for money is

related to income and interest .
Aggregate Money Demand
Figure 2: Aggregate Real Money Demand and the Interest Rate
Interest
rate, R

i(1) L(R,Y)

Aggregate real
money demand
Inflation and interest rates
▪ Nominal interest rate, i
not adjusted for inflation
▪ Real interest rate, r
adjusted for inflation:
r = i −p

29
The Fisher effect
▪ The Fisher equation: i = r + p
▪ Hence, an increase in p
causes an equal increase in i.
▪ This one-for-one relationship
is called the Fisher effect.

30
U.S. inflation and nominal interest rates,
1960-2009

nominal
interest rate

inflation rate
NOW YOU TRY:
Applying the theory
Suppose V is constant, M is growing 5% per year,
Y is growing 2% per year, and r = 4.
a. Solve for i.
b. If the Fed increases the money growth rate by
2 percentage points per year, find Di.
c. Suppose the growth rate of Y falls to 1% per
year.
▪ What will happen to p ?
▪ What must the Fed do if it wishes to
keep p constant?
NOW YOU TRY:
Answers
V is constant, M grows 5% per year,
Y grows 2% per year, r = 4.
a. First, find p = 5-2 = 3.
Then, find i = r + p = 4 + 3 = 7.
b. Di = 2, same as the increase in the money
growth rate.
c. If the Fed does nothing, Dp = 1.
To prevent inflation from rising,
Fed must reduce the money growth rate by
1 percentage point per year.
Supply of
Money
 How the Money Supply Is
Determined

• An economy’s money supply is controlled by its central bank.

• The central bank:
• Directly regulates the amount of currency in existence
• Indirectly controls the amount of chequing deposits issued by private
banks
 Money Supply

M=C+D

C = Currency: coins & bills (13.5%)

D = Demand Deposits: checking

account deposits (86.5%)
Concepts of Money
 Money Supply Function

M=C+D
H=C+R

where M = money supply

C = currency with public
D = bank deposits
H = high powered money
R = bank reserves
• High powered money, is also known as reserve money, government money and
monetary base (it has the capacity to create more money and it represents the
liabilities of the government
 A few preliminaries
• Reserves (R ): the portion of deposits that banks
have not lent.

• To a bank, liabilities include deposits,

assets include reserves and outstanding loans

• 100-percent-reserve banking: a system in which

banks hold all deposits as reserves.

• Fractional-reserve banking:
a system in which banks hold a fraction of their
deposits as reserves.
Money creation in the banking system

A fractional reserve banking system

creates money,
but it doesn’t create wealth:
bank loans give borrowers
some new money
and an equal amount of new debt.
 Money Multiplier

➢Money multiplier is the process through

which banks create more money through its
excess reserves, thereby expanding money
supply.

➢In other words, its process of creating

more money by banks from reserve money.
 Money Multiplier

In order to derive a money Multiplier we have to

divide the total money supply with Reserve Money
M/B= C+D/C+R
Divide both the top and the bottom with D
M/B=C/D+1/C/D+R/D
of which
C/D-Currency deposit Ratio -cr
R/D is Reserve-Deposit Ratio- rr
Replace them appropriately and Bring B to right
side
 Money Multiplier
Then,
M=(cr+1/cr+rr ) *B

This equation shows how the money

supply depends on the three exogenous
variable
We can also see that the money supply is
proportional to the monetary base. i.e.,
M= m*B
 Money Multiplier Example
Suppose that the monetary base B is $800
billion,
the reserve–deposit ratio rr is 0.1, and the
currency–deposit ratio cr is 0.8.

1. What is the Value of money multiplier is?

2. What is the Money Supply
 Money Multiplier Example

1 Ans. Money multiplier is m=0.8+1/0.8+0.1 = 2.0

2. The money supply is M = 2.0 × $800 billion =

$1,600 billion
The Equilibrium Interest Rate: The
Interaction of Money Supply and Demand

• Equilibrium in the Money Market

• The condition for equilibrium in the money market is:
Ms = Md
• The money market equilibrium condition can be expressed
in terms of aggregate real money demand as:
Ms/P = L(R,Y)
 Change in Money Supply
• The money supply is proportional to the monetary
base. So, an increase in H increases M m-fold.

• The lower the reserve-deposit ratio, the more loans

banks make and the higher is the money multiplier

• The lower the currency deposit ratio, the fewer rupees

of the monetary base the public holds as currency and
the larger is the money multiplier
The Equilibrium Interest Rate: The
Interaction of Money Supply and Demand
Figure : Determination of the
Interest Equilibrium Interest Rate
rate, R
Real money supply

2
R2

1 Aggregate real
R1 money demand,
3 L(R,Y)
R3

Q2 MS ( = Q 1 ) Q3 Real money
P holdings
 The Equilibrium Interest Rate: The
Interaction of Money Supply and Demand

• Interest Rates and the Money Supply

• An increase (fall) in the money supply lowers (raises) the
interest rate, given the price level and output.
• The effect of increasing the money supply at a given price
level is illustrated in the next Figure
The Equilibrium Interest Rate: The
Interaction of Money Supply and Demand
Figure : Effect of an Increase in the Money
Supply on the Interest Rate
Interest
rate, R
Real money
supply Real money
supply increase

1
R1

R2 2

L(R,Y1)

M1 M2 Real money
P P holdings
The Equilibrium Interest Rate: The
Interaction of Money Supply and Demand

• Output and the Interest Rate

• An increase (fall) in real output raises (lowers) the
interest rate, given the price level and the money
supply.
• Next Figure shows the effect on the interest rate of a
rise in the level of output, given the money supply and
the price level.
The Equilibrium Interest Rate: The
Interaction of Money Supply and Demand
Figure: Effect on the Interest
Interest Rate of a Rise in Real Income
rate, R
Real money supply

Increase in
real income

2
R2
1 1'
R1 L(R,Y2)
L(R,Y1)

MS ( = Q 1 ) Q2 Real money
P holdings
Inflation
The meaning of inflation

• Considerable and persistent rise in the general level of

prices over a long period of time
• Persistent- price rise exhibits a secular trend over a
period of time (1-2 yrs) and does not respond to anti-
inflationary policies
• Appreciable – difficult to answer and depends on the
absorption capacity of the economy
• Moderate rate of inflation keeps- economic outlook
optimistic, promotes economic activity, prevents
economic stagnation, mobilizes resources by increasing S
and I
• A rate of inflation higher than the desirable rate of
inflation is considered “considerable”
• Economy gets overheated and aggregates get adversely affected
• 2-3% in developed and 4-6% in developing countries is desirable
• Any price rise above than this is inflation?
No
▪A price rise due to change in the
composition of GDP in which higher priced
industrial products replacing low priced
agricultural produce
▪Due to qualitative changes
▪Due to price indexing system
▪Due to recovery in price after recession
 Measures of inflation
• % change in price index number (PIN)
• Rate of inflation = (PINt – PINt-1/PINt-1 ). 100
• CPI- 1981-82=100 increased from 182.7 in 1990-91 to
207.8 in 1991-92
• Rate of inflation = (207.8 – 182.7/182.7) . 100
• = 13.75%
 Types of inflation

• Classification on the basis of rates and its causes

• Moderate or creeping inflation- single digit inflation,
normally predictable, people faith in money as a store of
value and monetary system intact, money continues to be
medium of exchange
• Galloping inflation -in double or even triple digit,
exceptionally high 10-999%, economic impacts
devastating.
Hyper Inflation

• Hyper inflation-more than three digit rate per annum,

paper currency becomes worthless, from Jan 1922 to
Nov 1923 the German price index rose from 1 to 10,
000,000,000
• Germany- to pay large costs of World War 1 Germany
suspended convertibility of its currency into gold and
war was funded by borrowing, exchange rate of the
Mark against the US $ fell and hyperinflation broke
out
Hyperinflation

• Money ceases to function as a store of value, and may

not serve its other functions (unit of account,
medium of exchange).
• People may conduct transactions with barter or a
stable foreign currency.

9
What causes hyperinflation?

•Hyperinflation is caused by excessive

money supply growth:
•When the central bank prints money,
the price level rises.
•If it prints money rapidly enough, the
result is hyperinflation.

10
A few recent examples of hyperinflation
CPI Inflation M2 Growth
country period
% per year % per year
Israel 1983-85 338% 305%
Brazil 1987-94 1256% 1451%
Bolivia 1983-86 1818% 1727%
Ukraine 1992-94 2089% 1029%
Argentina 1988-90 2671% 1583%
Dem. Republic
1990-96 3039% 2373%
of Congo / Zaire
Angola 1995-96 4145% 4106%
Peru 1988-90 5050% 3517%
Zimbabwe 2005-09 489 Billion% -
Economic effects of inflation
Economic effects of inflation

• Distribution of income
• it affects price received (factor incomes) and price paid
(expenditure)
• if both increase in the same proportion, income
distribution remains unaffected
• but profits rise faster, profit earners benefitted
• If inflation predictable- inflation-consumption pattern is
adjusted by moving from low-wage jobs to high wage
jobs, impact is considerably mitigated
Economic effects of inflation

• Distribution of wealth
• if prices of all price variable assets increase at the rate of
inflation then no change in the asset portfolio (price
variable assets are physical assets such as land, building,
jewelry, financial assets such as shares
• fixed claim assets like bonds, term deposits etc and
liabilities like house loan will loose its networth.
Economic effects of inflation

• Wage earners
• are hurt
• organized labour market-wage rises in line with inflation
• Unorganized sector labour is net looser
• Producers
• rate of increase in price v/s input price
• input prices being same profit increases putting pressure
on input demand pushing its prices up with time lag
• producers gain due to wage-lag.
Economic effects of inflation

•Fixed income class- net losers

•Borrowers and lenders- borrowers gain and
lenders loose
•The government
• net gainer- govt as taxing and spending unit and borrower,
inflation increases yield from direct and indirect taxes- inflation
redistributes income in favour of higher income group
enlarging tax base, inflation also increases nominal income so
nontaxable income now becoming taxable and higher tax rate
possible, yield from corporate tax also increases as profit
increases
• indirect taxes imposed at fixed rate or ad velorem
Economic effects of inflation

• Economic growth
• rate of economic growth depends on the rate of capital
formation depends on S & I
• Wage lag persists over long time enhancing profit
>increase in investment, production capacity and higher
level of output
• Redistribution of income in favour of profit earners >
increase in S as low MPC > more investment and growth
Economic effects of inflation

• A moderate of inflation breaks the “rigidities and

immobility” in developing and/or underdeveloped
countries –movement from traditional and subsistence
sector to developing sector > efficient reallocation of
resources
• Divergence in view
• Low inflation and high growth in West Germany
• High inflation high growth in Japan and the US
• Low inflation and low growth in India
Causes of Inflation
 Causes of inflation
• Classical quantity theory of money (Irving Fisher- 1911)- inflation
occurs in direct proportion to increase in money supply
MV=PT P= MV/T
• Or in terms of % change
m+v=p+y
p=m+v–y
• Where p is rate of inflation, m % change in money supply, v is %
change in velocity of money and y is % change in real output
• V and y are given in the short run, m is subject to variation
depending on monetary policy, full employment
• Drawback-it does not explain the process
Keynesian theory of inflation

• Increase in aggregate demand caused by increase in real

factors like C (rise in MPC), I and G, even if Ms is
constant causing demand-supply gap termed as
inflationary gap (planned expenditure in excess of output
available at full employment level)
Modern approach using price theory

• Cost Push Inflation- Cost-push inflation occurs

when businesses respond to rising production costs,
by raising prices in order to maintain their profit
margins. reasons for costs rise:
• Rising labour costs - wage increases which exceed any
improvement in productivity in ‘labour-intensive industries,
wage inflation tends to move closely with price inflation
because there are limits to the extent to which any business
can absorb higher wage expenses
Cost Push Inflation

• Higher indirect taxes imposed by the government –a

rise in the rate of excise duty on alcohol and cigarettes, an
increase in fuel duties For example, if a new tax on
aviation fuel, then this would contribute to a rise in cost-
push inflation. Incidence of tax
• A rise in the imported raw material costs
 Demand Pull Inflation

• Demand-pull inflation -full employment of resources and SRAS is inelastic.

• A depreciation of the exchange rate, which has the effect of increasing the
price of imports and reduces the foreign price of Indian exports. If
consumers buy fewer imports, while foreigners buy more exports, AD will
rise. If the economy is already at full employment, prices are pulled upwards.
• A reduction in direct or indirect taxation.
Cure of Inflation
Anti inflationary measures
•Monetary Measures
•Fiscal Measures
•Regulatory Measures
 Long Term Policies to Control
Inflation
• Labor Market Reforms: By controlling labor costs
through part time and temporary working. Also
weakening of trade union power.
• Supply Side Reforms: Supply side reforms seek to
increase the productive capacity of the economy in the
long run to meet demand.
1
Components of Consumption
 Non durable goods
◦ Short lived goods; disappear
(or become useless) with
consumption
◦ Expenditure is stable in nature
 Durable goods
◦ Long-lived consumer goods;
◦ Have long lives and
◦ Consumed gradually (again
and again) over time
◦ Subject to depreciation
◦ Expenditure is most volatile
 Services
◦ All non durable; consists of
services provided
◦ Partially pro-cyclical in nature
Consumption
Consumption expenditure:
In India: Accounts for 58 per cent of GDP
World Avg. : Accounts for 62 per cent of GDP
USA : Accounts for 71 per cent of GDP
 Introduction
 Consumption function is the functional relationship between
the aggregate income, aggregate saving and aggregate
consumption
 It has received significant importance in Economic theory
after J M Keynes made it a keystone of his theoretical structure
of “General Theory of Employment, Interest and Money”.

4
The Pre-Keynesian Consumption Function

 In microeconomic theory,
when households have a
large number of goods and
services to choose from, an
important variable
influencing the demand for
a specific good is its price
relative to all other goods
and services:

Qd = f(P), ceteris paribus

The Pre-Keynesian Consumption Function

 When we construct a
macroeconomic
consumption function,
we take the relative
price of goods as given.

 We focus on how
households divide their
expenditure between
consumption of all
goods and services and
saving.

YC+S
The Pre-Keynesian Consumption Function

 Rewriting the
identity, we can
define planned
savings as being that
part of income which
households do not
intend to spend on
consumption:

SY-C
The Pre-Keynesian Consumption Function
 In the pre-Keynesian era, the
predominant view was that
the rate of interest was the
main variable influencing the
division of income between C
and S.
 The pre-Keynesian savings
and consumption functions
can be written as:
S = f(r)
C = f(r)
 The Keynesian Consumption Function
 Keynes accepted that the rate of interest
was a variable which influenced
consumption decisions, but he believed
that the level of income was more
important.
C = f(Y)
S = f(Y)
‘The fundamental psychological law, upon
which we depend is that men, as a rule
and on average, increase their
consumption as their income increases,
but not by as much as the increase in
their income’
 The Keynesian Consumption Function
 The consumption function
describes the relationship
between consumer spending
and income
C = Ca + by
 Consumption spending, C,
has two parts:
◦ Ca = autonomous
consumption. This is the
part of total consumption
which does not vary with
the level of income.
The Keynesian Consumption Function
◦ by = income-induced consumption. The product of a
fraction, b, called the marginal propensity to consume
(MPC) and the level of income, y.
 The consumption function is a line that intersects the
vertical axis at Ca. It has a slope equal to b.
 The consumption function relates consumer
spending to the level of income.

Consumption
function (Ca + by)
Demand

Ca

0
Output, y
 Consumption
function (Ca + by)
Demand

slope b

Ca
autonomous
consumption
{ Output, y
0
 The Consumption Function

 Although output is on the horizontal axis,

output and income in this simple economy
are identical
 Output generates income that is all
received by households
 As output rises by $1, consumption
increases by the marginal propensity to
consume (b) times $1
Marginal Propensity To Consume (MPC)

 The MPC is always less than 1.

 Suppose the MPC = .75
 An increase in income of $100 would
increase consumption by
by
=
.75 x $100
=
$75
Marginal Propensity To Consume (MPC)

 If a consumer receives a dollar of income,

consumer will spend some of it and save the rest.

 The fraction that the consumer spends is

determined by the MPC

 The fraction of income that the consumer saves is

determined by the marginal propensity to save
(MPS)

 The sum of the MPC and MPS is always 1

Changes In The Consumption Function

 The level of autonomous consumption and the MPC

can change causing movements in the consumption
function
 If the level of autonomous consumption is higher, it
will shift the entire consumption function.
 Changes in the marginal propensity to consume will
change the slope of the consumption function.
 Autonomous Consumption Changes

 Increases in consumer wealth will cause an

increase in autonomous consumption.

 Consumer wealth consists of the value of

assets that individual owns and consumer
durables.

 Increases in consumer confidence will

increase autonomous consumption.
 Movements of The Consumption Function
Demand

Ca1

Ca0

Output, y

An increase in autonomous consumption

from Ca0 to Ca1 shifts the entire consumption
function.
Marginal Propensity To Consume Changes

 Consumers’ perceptions of changes in their

income affect their MPC

 If consumers believe that an increase in their

income is permanent, they will consume a
higher fraction of the increased income than
if the increase were believed to be
temporary
Movements Of The Consumption Function

Slope b1
Demand

Slope b

Output, y

An increase in MPC from b to b1 increases the slope

of the consumption function.
 Three Conjectures of Keynesian
Consumption Function

1. 0 < MPC < 1

2. Average propensity to consume (APC )
falls as income rises.
(APC = C/Y )
3. Income is the main determinant of
consumption.
Investment

MEBE Section K 23
 Investment
Here, we are trying to
understand:-

 types of investment
 why investment is
negatively related to the
interest rate
 things that shift the
investment function
 why investment rises
during booms and falls
during recessions
 Investment: Definition
 In Keynesian view, investment
refers to real investment
which adds to capital
equipment. It leads to
increase in level of income
and production by increasing
the purchase of capital goods.

 “By investment it is meant an

addition to capital, such as
occurs when a new house is
built or a new factory is built.
Investment means making an
addition to the stock of
goods in existing.” (Joan
Robinson)
 Three types of
investment
 Business fixed investment:
businesses’ spending on
equipment and structures for
use in production.
 Residential investment:
purchases of new housing units
(either by occupants or
landlords).
 Inventory investment:
the value of the change in
inventories of finished goods,
materials and supplies, and
work in progress.
Investment
 Investment plays two
roles in
macroeconomics:
◦ It can have a major
impact on AD (real
output and employment)

◦ It leads to capital
accumulation (it
increases the nation's
potential output and
promotes economic
growth in the long run)
 Determinants of Investment
 Returns: an investment should bring the firm
additional revenue.
 Costs: interest rate influences the costs of the
investment.
 Expectation: business expectation about future
state of economy.
Investment Spending
 Investment is the change in the capital
stock
In,t = Kt – Kt-1 = Gross Investment

Ig,t = Kt – Kt-1 – Kt = Net Investment

(Kt is depreciation)
The Interest Rate- Investment Relationship

 Investment consists of
spending on new plants,
capital equipment,
machinery, inventories,
construction, etc.

 The investment
decision weighs
marginal benefits and
marginal costs.
 expected rate of return from investment is
the marginal benefit

 interest rate - the cost of borrowing funds -

represents the marginal cost.
Causes of changes in expected returns

1. Acquisition, maintenance, and operating

costs
2. Business taxes
3. Technology
4. Capacity Utilisation
5. Expectations
 Investment demand Curve
 Investment demand schedule, or curve, shows
an inverse relationship between the interest
rate and amount of investment.
 As long as expected return exceeds interest
rate, the investment is expected to be
profitable.
◦ fewer projects are expected to have return higher
than interest rate, if interest rates are high → less
will be invested.
◦ it shows an inverse relationship between real
interest rate and investment demand.
The Investment Schedule
_
I I bi Where b>0

Investment
Schedule explains
the combinations
of level of
investment and
rate of interest
Determinants of Investment

A change in any of the determinants of

investment will cause a shift in the investment
function (investment demand curve).

For example, if factor costs increase, the

investment demand curve will shift to the left. If
improved economic conditions are expected, the
investment demand curve will shift to the right.
 Investment Demand And Interest Rates

11 Better expectations cause a shift rightward

10 Movement up the existing curve
Interest Rate (percent per year)

9 is caused by an increase in interest rates

8
7
6 I2
5 Initial expectations
4 11
3 Worse expectations -
The curve shifts left I3
2
1

0 100 200 300 400 500

Planned Investment Spending (billions of dollars per year)
Government Spending (G)
 Government spending (G)
 G includes all government spending on
goods and services.
 G excludes transfer payments
(e.g., unemployment insurance payments),
because they do not represent spending on
goods and services.
 Note: Transfer payments are included in “government
outlays,” but not in government spending. People who receive
transfer payments use these funds to pay for their
consumption. Thus, we avoid double-counting by excluding
transfer payments from G.
Government in the Circular Flow Model

 Supplies goods and services to business firms

and households
 Demands resources in resource markets
 Taxes household income and business
revenues
 Transfers income to households
 Keynesian Cross
In The General Theory Keynes proposed that an
economy’s total income was, in the short run,
determined largely by the spending plans of
households, businesses, and government. The more
people want to spend, the more goods and services
firms can sell. The more firms can sell, the more output
they will choose to produce and the more workers they
will choose to hire. Keynes believed that the problem
during recessions and depressions was inadequate
spending. The Keynesian cross is an attempt to
model this.
 Keynesian Cross
Two Important Components of Keynesian Cross are:-

1. Planned Expenditure (is the amount households,

firms, and the government would like to spend on
goods and services).

2. Actual Expenditure (is the amount households,

firms, and the government spend on goods and
services, and it equals the economy’s gross
domestic product (GDP))
 Keynesian Cross

Planned Expenditure PE as the sum of consumption

C, planned investment I, and government purchases G
PE = C + I + G.
C = C(Y − T).
Assume Investment, Government Expenditure and
Taxes are exogenously fixed
Graphing planned expenditure
PE
planned
expenditure
PE =C +I +G

MPC
1

income, output, Y

44
 Keynesian Cross
The economy is in equilibrium when actual
expenditure equals planned expenditure. This
assumption is based on the idea that when people’s
plans have been realized, they have no reason to change
what they are doing. Recalling that Y as GDP equals
not only total income but also total actual expenditure
on goods and services, we can write this equilibrium
condition as
Actual Expenditure = Planned Expenditure
Y=PE.
Graphing the equilibrium condition
PE
planned PE =Y
expenditure

45º

income, output, Y

46
 Keynesian Cross
The 45-degree line in the Figure plots the points where
this condition holds. With the addition of the planned-
expenditure function, this diagram becomes
the Keynesian cross. The equilibrium of this economy
is at point A, where the planned-expenditure function
crosses the 45-degree line.
The equilibrium value of income
PE
planned PE =Y
expenditure
PE =C +I +G

income, output, Y
Equilibrium
income

48
 An increase in government purchases
PE
At Y1, PE =C +I +G2
there is now an
unplanned drop in PE =C +I +G1
inventory…

G
…so firms increase
output, and income
rises toward a new Y
equilibrium.
PE1 = Y1 Y PE2 = Y2

49
The Multiplier - Introduction
 We now need to introduce the Multiplier
theory and investigate in more detail the
process by which income or output
changes when an autonomous change
occurs in any of the components of
aggregate demand.
The Multiplier - Brief History1
 Concept first developed by Richard Kahn
in 1930-31.
 Keynes first made use of Kahn’s
multiplier in 1933, when he discussed the
effects of an increase in government
spending of £500 (a sum assumed to be
just sufficient to employ a man for one
year in the construction of public works)
The Multiplier - Brief History - 2
 Keynes wrote:
‘If the new expenditure is additional and not
merely in substitution for other expenditure, the
increase of employment does not stop there. The
additional wages and other incomes paid out are
spent on additional purchases, which in turn lead
to further employment . . . the newly employed
who supply the increased purchases of those
employed on the new capital works will, in their
turn, spend more, thus adding to the employment
of others; and so on’
 The Multiplier - Brief History - 3
 By the time of the publication of the
General Theory in 1936, Keynes had placed
the multiplier at the heart of how an
economy can settle into an
underemployment equilibrium.
 In the General Theory, Keynes focused
attention on the investment multiplier,
explaining how a collapse in investment
and business confidence can cause a
multiple contraction of output.
 The Multiplier In Action - 1
 From this, it was only a short step to suggest
how the government spending multiplier
might be used to reverse the process.
 Example:
◦ Let’s assume that the MPC is 0.8 at all levels of income
(MPS = 0.2)
◦ Whenever income increases by $10, consumption
increases by $8 and $2 is saved.
◦ We assume that prices remain constant, and that a margin
of spare capacity and unemployed labour exists which the
government wishes to reduce.
The Multiplier In Action - 2
 Suppose the government increases public
expenditure by $1 million, keeping
taxation at its existing level.

 The government could increase transfer

payments. Alternatively, the government
might wish to invest in public works or
social capital (e.g. road construction).
 Initial increase in income large
 Households spend 0.8 of their increase in
income on consumption ($800,000)
 Further stages of income generation occur,
with each successive stage being smaller than
the previous one.
The Multiplier In Action - 4
 The eventual increase in income resulting
from the initial injection is the sum of all
the stages of income generation
The value of the government spending multiplier =
Change in income
Change in government spending
or
k = Y
G
The Multiplier In Action - 5
 Providing that saving is the only leakage of demand,
the value of k depends upon the MPC.
 The formula for the multiplier in this model is:
k= 1
1-b
(where b = MPC)
 The larger the MPC, the larger the value of the
multiplier.
 Solving for Y
equilibrium condition

in changes
because I exogenous

because  C = MPC  Y

Collect terms with  Y Solve for  Y :

on the left side of the
equals sign:

59
The government purchases multiplier

Definition: the increase in income resulting from a $1

increase in G.
In this model, the govt
purchases multiplier equals

Example: If MPC = 0.8, then

An increase in G
causes income to
increase 5 times
as much!

60
Why the multiplier is greater than 1?

 Initially, the increase in G causes an equal increase

in Y:  Y =  G.
 But  Y  C
further  Y
further  C
further  Y
 So the final impact on income is much bigger than
the initial change in G.

61
 An increase in taxes
PE
Initially, the tax
increase reduces PE =C1 +I +G
consumption, and PE =C2 +I +G
therefore PE:

C = MPC x  T At Y1, there is now an

unplanned
inventory buildup…
…so firms reduce
output, and
income falls Y
toward a new Y
PE2 = Y2 PE1 = Y1
equilibrium

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 Solving for Y
eq’m condition in changes

I and G exogenous

Solving for Y :

Final result:

63
 The tax multiplier
def: the change in income resulting from
a $1 increase in T :

If MPC = 0.8, then the tax multiplier equals

64
The tax multiplier
…is negative:
A tax increase reduces C,
which reduces income.

A change in taxes has a

multiplier effect on income.
…is smaller than the govt spending multiplier:
Consumers save the fraction (1 – MPC) of a tax cut,
so the initial boost in spending from a tax cut is
smaller than from an equal increase in G.

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Multiplier and economic policy
 Implications are that it is possible to use
discretionary fiscal policy to control or
influence the level of aggregate demand.
 Monetarists would dispute the beneficial
effects - would point to the ‘crowding out’
effects of a widening budget deficit.