Introduction to
Macroeconomics
NASEER SHAHZADA
economypk@yahoo.com
NASEER SHAHZADA
Contents
• National Income Accounting
• Aggregate Demand and Aggregate Supply
• Macroeconomic Equilibrium
• Money and Banking
• Integration of Goods and Money Markets (IS-LM)
• Fiscal and Monetary Policies
• Business Cycles
• Inflation and Unemployment
• International Trade and Balance of Payments
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Why to study Macroeconomics?
• To understand the functioning of an economy
– What causes fluctuations in demand?
– What leads to instability in interest rates, prices
(inflation rates), exchange rates?
• To understand the direction of govt. policies
• To take a decision on timing of fresh investments,
takeovers, enter new markets, etc.
• To get best return on investment
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Macroeconomic – An Introduction
• Macroeconomics – study of the behavior and
performance of the economy as a whole
• Study of factors or forces determining the level
and growth of macroeconomic aggregates
• Macroeconomic aggregates (macroeconomic
variables) – output, income, employment, price
level, balance of payment positions, etc.
• Aggregate behavior refers to the behavior of all
households and firms together.
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Concepts in Macroeconomic Analysis
Stock and Flow Variables
• Stock: quantity of a variable at a point in time
Eg: Capital stock, money supply, unemployment
level, foreign exchange reserve, etc.
• Flow: quantity expressed for a period of time
Eg: GDP, inflation, exports, consumption, etc.
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Concepts in Macroeconomic Analysis
Aggregate Demand and Aggregate Supply
• Aggregate Demand: sum of demands for all
consumer goods and services and for capital goods
Sum of consumption, investment, government
expenditure and net export.
• Aggregate Supply: sum of the supplies of all
consumer goods and services and of capital goods
The amount of output the economy can produce
given the resources and technology available
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The Roots of Macroeconomics
• The Great Depression was a period of
severe economic contraction and high
unemployment that began in 1929 and
continued throughout the 1930s.
• A recession is a period during which aggregate output
declines. Two consecutive quarters of decrease in output
signal a recession.
• A prolonged and deep recession becomes a depression.
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The Roots of Macroeconomics
• Classical economists applied microeconomic models, or
“market clearing” models, to economy-wide problems
• Main argument: ‘Supply creates its own demand’- Say’s
law
• No intervention by the government (Laissez faire).
Economy should be left to market forces (‘invisible
hand’)
• The failure of classical models to explain the prolonged
existence of high unemployment during the Great
Depression led to the development of macroeconomics
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The Roots of Macroeconomics
• In 1936, John Maynard Keynes published The General
Theory of Employment, Interest, and Money.
• Keynes arguments:
– The level of output and employment in an economy is
determined by the aggregate demand (AD)
– Governments could intervene in the economy and
affect the level of output and employment
• Two important objectives of macroeconomic policies:
(a) Sustained growth in GDP, and (b) Price stability
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Functions of an Economy
• An economy is a complex arrangements of many
different buyers and sellers – households, businesses,
government, and the rest of the world – and of their
interactions with each other
• An economy employs various resources to produce a
variety of goods and services for domestic and world
consumption, and provides income for the resources
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The Components of the Macro
Economy
• An economy can be pictured as a schematic of closely
linked sectors – households, businesses, financial
institutions, governments, and foreigners
• A change in one sector’s transaction with another
sector will trigger changes in the entire schematic
• The circular flow of income and output diagram
shows the income received and payments made by
each sector of the economy
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Two-sectors Circular Flow
Income
Labor, land,
capital,
entrepreneurship
Households
Factor
Market
Wages, rent,
interest, profit
Inputs for
production
Financial
Sector
Saving
Goods &
Services bought
Spending
Investment
Product
Market
Business/
Firms
Goods &
Services sold
Revenue
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Three-sectors Circular Flow
Factor
Market
Direct taxes
Households
Wages, rent, interest, profit
Direct/Indirect taxes
Government
Govt. expenditure (G)
Business/
Firms
Govt. expenditure (G)
Financial
Market
Saving = Investment (S=I)
Product
Market
Consumption Spending (C)
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Four-sectors Circular Flow
External
Sector
Remittances
Receipts from exports
Export of services
Payments for imports
Wages, rent, interest, profit
Direct taxes
Households
Direct/Indirect taxes
Government
Govt. expenditure (G)
Govt. expenditure (G)
Saving = Investment (S=I)
Consumption Spending
(C)
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Business/
Firms
The Three Market Arenas
• Households, firms, the government, and the rest of the
world all interact in the goods-and-services, labor, and
money markets.
Who create demand and supply in these markets?
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Leakages and Injections
• Leakage/Withdrawal: is the amount that is set aside by
the households, firms, and governments and is not spent
on the domestically produced goods and services over a
period of time
• They reduce the size of the circular flow
Ex: savings, taxes, imports
• Injection/Addition: is the amount spent by households
and firms in addition to their regular incomes and receipts
• Injections increase the size of the circular flow
Ex: investments, govt. expenditures, exports
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National Income
Accounting
National Income –
Concepts and Measurement
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Why National Income Accounting?
 Provides common standards of measurement of
the size of an economy
 Helps to evaluate the economic condition of a
country and to compare conditions across time
and across countries
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National Income – Concepts
Different concepts of NI - The Criteria
(i) Items included in or excluded from the NI concept
(ii) Method of estimating NI
Gross Domestic Product (GDP)
• The sum of market value of all final goods and
services produced in a country during a specified
period of time, generally one year.
GDP   Qi Pi
• Also called GDP at market prices (GDPMP)
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National Income – Concepts
• Market values of final goods and services are taken
• Includes net indirect taxes
• Considers only final goods and services
• Intermediate goods are excluded to avoid the problem of
double-counting
• Considers output produced in a year
• The year of production, not the year of sale
• Inventory as such is not included, but changes in inventory*
is considered
*Changes
in inventory count output that is produced but not sold in a given year
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National Income – Concepts
GDP at factor cost (GDPFC) is the sum of all factor
payments (wages, interest, rent, profits and
depreciation)
GDPFC= GDPMP – Net indirect taxes
(Net indirect taxes = Indirect taxes – Subsidies)
Gross National Product (GNP)
The concept of GNP is similar to GDP, but with a
significant difference.
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GDP vs. GNP
GDP measures the total value of goods and services that
are produced within a country’s geographical borders
• Example: An Indian MNC in China will actually contribute to
Chinese GDP
GNP measures the total value of all final goods and
services that a country’s citizens produce regardless
of where they produce them
• Example: Profits of Indian MNCs earn in overseas market is
included in India’s GNP
GNP = GDP + NFIA (Net Factor Income from Abroad)
(NFIA=income earned by residents abroad – income earned by nonresidents from our country)
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National Income – Concepts
Net National Product (NNP)
• GNP included final consumer goods + capital goods
• Depreciation: part of capital goods that is used up
or consumed in the process of production
• Usually covered under Gross Investment
(Gross Investment = Net Investment + Replacement
Investment/Depreciation)
• NNP = GNP – Depreciation
• NNPFC = NI (the actual measure of National Income)
• Per Capita Income = (NNPFC = NI ) / Total Population
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National Income – Concepts
Personal Income (PI)
• The sum of all kinds of income received by the individuals
from all sources of income
• The share of NI actually received by the HH sector
Personal Income (PI) = National Income (NI)
Minus – Income earned but not received (undistributed corporate profits,
Plus
social security contributions by the HHs (PF, pension funds), etc.)
+ Income received but not earned now (transfer payments by
business and govt. to HHs, dividend income, etc.)
Disposable Personal Income (DPI): the income at the
disposal of a person
DPI = PI – Direct taxes
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National Income – Concepts
Nominal and Real GNP
• GNP is estimated at current and constant prices
• Nominal GNP: market value of all final goods and
services measured in current year prices
• Real GNP: market value of all final goods and services
measured in the price of a base year (constant prices)
• Why do we estimate GNP at constant prices?
• How to convert the nominal (current) values into real
(constant) values?
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National Income – Concepts
GNP Deflator
• An index of price changes for goods and services
included in GNP
• Used to deflate the nominal GNP to eliminate the
price effect to find real GNP for any year
Real GNP = Nominal GNP / GNP Deflator
GNP Deflator = Nominal GNP / Real GNP x 100
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National Income Accounting
GDP (Gross Domestic Product)
(Rs. crore)
2006-07 2007-08
At current prices
Growth rate
At 2004-05 prices
Growth rate
2008-09
2009-10
2010-11
4283979 4947857 5582623PE 6550271QE 7877947AE
15.6
15.5
12.0
17.3
20.3
3564627 3893457 4162509PE 4493743QE 4879232AE
9.7
9.2
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6.8
8.0
8.6
National Income
Measurement
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Measurement of NI - Methods
• A complex process
• Product flows (Real flows) and Money flows (factor
payments and payments for goods and services)
• Three approaches of measuring NI:
– Product Approach
– Factor Income Approach
– Expenditure Approach
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Measurement of NI - Methods
The Product Method
• Also known as Output Method or Value Added
Method
• Either by valuing all the final goods and services
during a year OR
• By aggregating the values imparted (value added) to
the intermediate products at each stage of
production (to avoid Double Counting)
(Value added is the difference between the value of output and
the value of the intermediate goods used in the production of
that output)
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Measurement of NI - Methods
Method
• Classification of output under various categories
(15 sub-categories are currently used in India)
• Computation of gross value of output of each category by
multiplying the output of each category by their respective
market prices and adding them together
• OR by summing up the value added at each stage of
production
• This gives GDP at market prices
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Measurement of NI - Methods
Product Method – An illustration
Sectors
Total value in
Rupees Crores
Agriculture & allied activities
1000
plus
Manufacturing industries
3000
plus
Services & construction
4000
equals
GDP at market prices
8000
plus
Net factor income from abroad
1000
equals
GNP at market prices
9000
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Measurement of NI - Methods
The Income Method
• Also known as factor share method
• Sum of the incomes accruing to the basic factors of
production used in producing the national products
Rent + wages + interests + profits + depreciation =
GDP at factor cost
Plus net income from abroad = GNP at factor cost
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Measurement of NI - Methods
Factor Income Method – An illustration
Sectors
Total value in
Rupees Crores
Income from employment
1000
plus
Gross profits of companies
2000
plus
Gross profits of public sector
2000
plus
Rent
2000
equals
GDP at factor cost
7000
plus
Net factor income from abroad
1000
equals
GNP at factor cost
8000
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Measurement of NI - Methods
The Expenditure Method
• Measures NI at final expenditure stage
• Excluded all expenditure on intermediate goods
• Sum of all money spend by individuals, firms and
government within a year = GDP at market prices (Y)
=) Consumption (C) + Investment (I) + Government
Expenditure (G) + Exports and factor income from
abroad (X) - Imports and factor income paid abroad(M)
Y=C+I+G+X-M
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Measurement of NI - Methods
Expenditure Method – An illustration
Sectors
Total value
in Rupees
Crores
Consumer expenditure (C)
2000
plus
Gross business spending (investment) (I)
3000
plus
Govt. expenditure (G)
2000
equals Domestic expenditure at market prices (C
+ I + G)
7000
plus
Exports & factor income from abroad (X)
3000
minus
Imports & factor income paid abroad (M)
1000
equals GNP at market prices (C + I + G + X - M)
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9000
GDP Omissions
There are three types of omissions in the measurement
of GDP
1) Activities that are not part of GDP by definition
Transfer payments & gifts received, second-hand sales
(except brokerage), increase in share prices, etc..
2) Items left out because of measurement problem
All non-market transactions, unorganized sector, income
through illegal means (black money), etc..
3) Items related to the welfare of the people
Quality of life, distribution of income, environmental
damages, etc..
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Problems of measuring GNP
• Determining what is ‘final’ and what is not (problem of
double counting)
• Evaluation of non-marketed goods and services
Example: - The goods and services produced and consumed
at home, that never enter the market place
• The services of housewives, women at HHs.
• Many economic activities by unorganized sector
• Black money, black market items, income from illegal
activities and professions, etc.
• Does not consider certain factors affecting people’s
welfare (like income distribution, environmental damages)
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Exercise - 1
The following information is extracted from the National Income
Accounts of an economy for the year 2008-09
Particulars
Rs. In crore
GNP at factor price
95,000
Indirect taxes
14,000
NDP at market prices
1,00,422
NNP at market prices
1,00,000
GNP at market prices
1,07,000
Personal income taxes
10,000
Corporate profit tax
6,500
Retained profit
30,000
Compute (a) the value of depreciation; (b) the value of net factor income
from abroad; (c) the value of subsidies; (d) the value of NDP at factor cost;
(e) the value of national income; (f) the value of personal income; and (g)
the value of personal disposable income
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Exercise - 2
The following information is extracted from the National Income
Accounts of an economy for the year 2008-09
Particulars
NNP at factor price
Rs. In crore
4,73,246
Depreciation
61,809
Subsidies
19,431
Net Factor Income from abroad
-6,833
Indirect taxes
87,043
Personal income taxes
9,759
Corporate taxes
7,300
Retained profit
6,758
Compute (a) the value of GNP at market price; (b) the value of NNP at
market price; (c) the value of NDP at market prices; (d) the value of NDP at
factor cost; (e) the value of GNP at factor cost; and (f) the value of personal
disposable income
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References
1. Chapter 4 & 5, ‘Principles of Macroeconomics’
by Michael Melvin and William Boyes .
2. Chapters 1 & 2, ‘Macroeconomic Policy
Environment’ by Shyamal Roy.
3. Chapter 2, ‘Macroeconomics’ by R.
Dornbusch, S.Fischer, and R. Startz.
4. Chapter 2. Prof. A. Hamid Shahid
5. Chapter 2. Abel. Ben. bernanke
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