ECONIMICS
MICRO
INDU ENTITIES
(FIRM, GOOD)
MACRO
AGGREGATES
(UNEMPLOYMENT)
All govt. adopt Macro-economic policies with the following objectives:
1.
2.
3.
4.
5.
Economic growth and development
Price stability (decreasing inflection)
short term
Full employment
External equilibrium
Decreases income inequality (fair/ equitable distribution of income)
Circular flow of income
2 sector model.
GOODS
AND
SERVICES
HOUSE
HOLDS
FIRMS
FACTOR
SERVISES
(LAND
LABOR)
CONSUMPTION
EXPENDITURE
FIRMS
HOUSE
HOLD
FACTOR
INCOME
4 sector model.
TAX
HOUSE HOLDS
SAVING
GOVERMENT
BANKING
IMPORT
EXP
REST OF
THE WORLD
CONSUMPTION
EXP
FACTOR
INCOME/
PAYMENT
FIRMS
GOVT. EXP
LEAKAGES



TAXES
SAVINGS
IMPORT EXP
INJECTIONS
EXPORT
EARNING
S



EXPORTS EARNINGS
INVESTMENTS
GOVT. EXP
OUTPUT = INCOME = EXPENDUTURE
EXPENDUTURE




CONSUMPTION
GOVT EXP
INVESTMENT EXP
EXPORTS – IMPORT
Concepts of national income
Domestic vs. National
Gross domestic product (GDP): is the money value of all final goods and services produced within the
domestic territory of a country in an accounting year.
Income generated by Indian firms in India (Y1) + income generated by forging firms in India (Y2)
Gross national product (GNP): money value of all final goods and services produced by domestic factor
of production in an accounting year.
Income generated by Indian firms in India (Y1) + income generated by Indian firms abroad (Y3)
GNP = GDP +(Y3 – Y2)
(Y3 – Y2)  net property income from abroad (NPIA)
GNP > GDP: NPIA = +ve, net inflow of money
GNP = GDP: NPIA = 0
GNP < GNP: NPIA = -ve, net outflow of money
Gross vs. Net
Net Domestic Product (NDP): GDP – depreciation (capital consumption allowance) (the loss in value of
capital goods due to wear and tear)
Net National Product (NNP): GNP – depreciation
Market price vs. Factor cost
GDP, GNP, NDP, NNP  money value  calculated using the market price.
GDPMP (GDP at market price) – ((indirect tax – subsidies)  net indirect taxes)  GDP at factor cost.
GNPMP – net indirect taxes = GNPFC
GDPMP – net indirect taxes = GDPFC
NNPFC  national income.
Nominal vs. Real
Using GDP
Nominal GDP: if the GDP of the country for a particular year is calculated by taking the prices that
prevailed in that year, it is called nominal GDP or GDP at current prices.
Note
National income or GDP of a country is calculated in money terms. It represents the total output
produced in the country. However, the value of money is not constant and changes with inflation or
deflation. Therefore, it makes comparison of GDP in different periods inaccurately. The objective is to
find out the change in total production.
Real GDP:
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
𝑃𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙
Total vs. Per Capita
Using GDP
Total GDP
𝑇𝑜𝑡𝑎𝑙 𝐺𝐷𝑃
Per Capita GDP: 𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛  average
Commonly indicator of economic dev. (tells avg. standard of living)
AD/AS model
Aggregate demand (AD): is the sum total of all final goods and services demanded in an economy. It is a
relation between price level and real GDP/output. (The sum total of all individual demands). Is the same
as the total planned spending in an economy:




Households  consumption expenditure ‘C’
Producers/Firms  investment expenditure ‘I’
Government  govt. Expenditure ‘G’
Rest of the world  net exports ‘X (exports) –M (imports)’
Commodity
A
B
C
D
6460
∗ 100
3700
P1 (2005)
25
50
10
100
P2 (2010)
50
60
8
250
Weight (W)
40
30
20
10
Total
P1W
1000
1500
200
1000
3700
P2W
2000
1800
160
2500
6460
= 175IS THE PRICE LEVEL (price index)
Price level  price index
1. Consumer price index
2. GDP deflator
Inverse/negative relation
between P2 and real GDP
Price
level
(GDP
Deflators)
Real GDP/output
The negative relation between PL and AD can be explained by the following 2 effects:
1. Income effect: it states, if PL increases  lower purchasing power  decrease in real income 
lower AD.
2. Substitution effect: can be broken into 3 parts:
a. Net export effect: if PL increases  domestic goods become expensive  an increases
in demand for imported goods  (X-M) decreasing  AD falling.
b. Net interest rate effect: if PL increases  increases demand for loans  increases the
interest rates (r). this will result in 3 way
i. Saving increases  consumption decreases  AD decreases
ii. Borrowing for purchase of durable goods decreases  consumption decreases
AD decreases
iii. Investments decreases  AD decreases
c. Real balance effect: when PL increases the real value of bank deposits/balance fall this
results in increase savings and decrease in consumption therefore, AD decreases
Change in AD (shift)
Black: decreases
Blue: original
Red: increases
Price
level
Real GDP
AD will change if one of the components of AD that is consumption, investment, govt. exp., and net
exports changes
Consumption expenditure in an economy will change if:
a) Economic Growth: increase in National Income (NI)  increase in consumer income  increase
in consumption expenditure  AD increases and vice versa.
b) Interest Rate (r):
a. Increase in r  increases in savings decrease in consumption  decrease in AD and
vice versa.
b. Increase in r decrease in borrowing to purchase DG decrease in consumption 
decrease in AD and vice versa.
c) Consumer confidence: if people are confident and optimistic, about their economic future 
consumption increases  AD increases and vice versa (mostly happens in economic boom)
d) Wealth: increase in wealth  increase in consumption  increase in AD and vice vresa
Investment expenditure will change if
A) Economic growth  NI increases  income of people increases  demand increases 
investment increases (I)  AD increases and vice versa
B) Interest rate: r increases  I decreases  AD decreases and vice versa.
C) Business confidence: if business confidence is high  I increases  AD increases (mainly in
economic boom)
D) Technology  improvement in tech.  decrease in cost and increase in profits  I increase 
AD increase and vice versa.
Govt. Exp. In an economy will change if:
Govt. exp. depends on govt. policies
Net exports changes if
a) Exports changes: exports of a country will change (rise)(vice versa of the whole thing) if:
a. Economic growth in the countries where goods are exported to.
b. High rate of inflation in the countries where goods are exported to.
c. Devaluation of the domestic currency.
b) Imports change: imports of a country will change (rise)(vice versa of the whole thing) if:
a. Domestic economic experience growth
b. High rate of inflation
c. If the value of the domestic currency increases
Govt. policies affection AD
Also called demand side policies
It can be expansionary (if they increase AD) or contractionary (if they decrease AD).
1. Fiscal policy: are policies of the Govt. relating to tax rate (Direct tax) and govt. expenditure.
a. Expansionary fiscal policy (increase AD): the govt. will :
i. Decreases income tax rate will increases disposable income  increases
consumption exp.  AD increases.
ii. Decreases corporate tax incentive to invest  increases investment AD
increases
iii. Increase govt. exp. (G)  AD increases
Are generally adopted to increase economic growth
Decrease unemployment. Normally at time of recession.
iv. Consequence: budget deficit  deficit financing:
1. Borrowing (inflation)
2. Print money (inflation)
b. Contractionary fiscal policy: Is adopted at the times of high inflation
i. Increase direct tax (income & corporate) decreases AD
ii. Decrease govt. exp.  decreases AD
iii. Consequence:
1. Lower economic growth
2. Increases unemployment
iv. Good thing:
1. Decrease budget deficit
2. Decrease inflation
2. Monetary policy: is the policy of the govt. relating to the interest rate and the money supply.
a. Expansionary monetary policy (increase AD):
i. Reducing interest rate (r) (to do this):
1. Reduces bank rate (the rate of interest that the central bank charges
when commercial bank borrow) (if a c. bank borrow at a low interest
rate they will charge low interest while lending. Therefore, the interest
rate of c. bank will fall)  AD increases.
ii. Increase money supply (Ms)
1. Money supply (total amount of deposit and cash held by people in a
country) it can be controlled by govt. in 3 ways:
a. Cash reserve ratio (CRR): is the proportion of the deposits that
the c. bank have to hold as deposits with the c. bank. If CRR
decreases  less money with c. banks to lend. Vice versa
b. Statutory Liquidity ratio (SLR): is the proportion of the total
deposits that a c. bank needs to keep in form of govt. securities
or gold.
If SLR decreases less money to lend and vice
versa
c. Open market operation: refers to the selling and purchase govt.
securities. If the govt. wants to increases money supply it will
buy the securities and vice versa.
iii. +ve.
1. Increases eco. Growth
2. Decrease unemployment
iv. –ve.
1. Increase inflation
b. Contractionary monetary policy
i. Increases interest rate – increase bank rate
ii. Decrease Ms
1. Increases CRR
2. Increase SLR
3. By selling govt. securities
iii. +ve.
1. Decrease inflation
iv. –ve.
1. Decrease eco. Growth
2. Increase unemployment
Under money supply
Black: money supply decrease
Blue: original
Red: money supply increase
Interest
rate
Demand for money
Quantity of money
Aggregate supply (AS)
Is the sum total of all final goods and services that all industry in an economy plan to produce at
different price level. It is also equal to aggregate of all individual supply.
Short run: is the time period between which the prices of final goods and services can adjust to
equilibrium but factor prices do not. In short the product market can adjust to equilibrium but other
market cannot.
Long run: is the time period during which all market including the labor market adjusts to the
equilibrium.
Short run aggregate supply (SRAS)
The SRAS curve shows the relation between AS and the price level in the short run. It is the total amount
of output that all firms plan to produce at different price level.
d
Price level
[GDP
deflator]
c
a
b
Real GDP
SRAS curves have 3 sections:
1. a-b: the price level remain constant and real GDP charges. Represents mass unemployment and
underutilization of resources firms can keep on hiring without a rise in factor cost average
cost remain constant  profit will remain constant  intensive of price rise is not necessary to
increase production.
2. b-c: output will increase in Pl increases. In this section firms experiences increase in AC with
increase in production & hence require an incentive of price rise to increase production. That is
because law of diminishing marginal returns sat in and resource bottle neck (economy
experiences shortage of cretin skills.
3. c-d: with increase in Pl output does not chance  physical limit of production (reaches the
highest limit of PPC).
Since economy will normally operate in section b-c a normal SRAS curve will be drawn as a positively
sloped line representing that AS will only rise with the price level
Short run macro equilibrium
In the short run the economy will be at equilibrium at the where AD = SRAS
SRAS
Price level
E
AD
Real GDP
E is the point of equilibrium
Long run AS curve (LRAS)
Two views on the shape curve:
1. KEYNESIAN VIEW:
a. Extreme Keynesian view:
AD1
AS
AD2
Price level
E
Y1
AD3
Y*
Real GDP
i. Y*  physical limit of production  full employment output
ii. Wage – price rigidity
1. Wages are rigid  not fall below the accepted rate
2. Price are rigid  price do not fall  oligopoly
iii. Where the economy will operate depends on the position of AD curve (given the
AS curve)
Therefore, AD  AD1… economy will oprate at E.
Actual output = Y1 {Y1 < Y*} actual output < potential output
Therefore, unemployment > NRU
Therefore, to achieve full employment govt. should shift AD1 to AD2
 actual output = potential output  full employment
[AD can be shifted by expansionary demand side policies]
The government can increase AD without increasing PL
If AD  AD3  full employment but high inflation, govt. can decrease AD &
there by decrease inflation (by continuing demand side policy) without
increasing unemployment.
He gave a lot of stress to demand side policies & therefore believed in govt.
intervention to reduce unemployment & inflation
d
Price level
c
a
b
Real GDP
b.
i. Between a & b a change in AD (by demand side policy) will only change
employment but not price level.
ii. Between b & c a change in AD will effect both
iii. Between c & d a change in AD will effect only the PL
2. NEO-CLASSICA VIEW
a. Say’s Law: supply creates its own demand. AS increases  production increases
increase in income increase in AD. Therefore, in long run AS = AD.
b. Wage price flexibility: in the long run, wages and prices will adjust to restore equilibrium
whenever there is excess demand or supply in the market.
In the long run all market are in equilibrium  labor market is in equilibrium AD for labor is equal to
AS of labor unemployment t is at the natural rate (some amount of unemployment who are not
willing to work or are not able to work at full employment)  economy is operating at full employment
 economy is producing/operating at potential output.
LRAS
PL
Real GDP
No matter what is the PL, the economy will operate at potential output (full employment)
Case I
LRAS
SRAS
SRAS1
Price
level
E
AD
Y1
Y*
Real GDP
Short run  equilibrium is at E (SRAS = AD)
Output = Y1  Actual output
Actual output (Y1) < potential output (Y*)
 Unemployment > NRU (5%)
 ADL < ASL  excess supply of labor
Wages rate decreases  Av. Cost of production decreases  SRAS curve shifts to the right  till all
excess supply is eliminated  economy is operates at full emp.  actual output is = to pot. Output &
unemployment = NRUs
Case 2
SRAS1
LRAS
Price
level
SRAS
E
AD1
AD
Y*
Y1
Real GDP
Actual output (Y1) >potential output (Y*)  Unemployment < NRU  AD of labor > AS of labor 
increase in wage rate  increase in AC of production.  SEAS will shift to the left till excess demand
for labor is eliminated  economy operates at full emp.
Conclude: it the long run economy will operate at full emp.
Output = potential output
Shift of SRAS curve
SRAS
Price level
Real GDP
SRAS will increase if
1.
2.
3.
4.
5.
Decrease in wage rate
Decrease resource cost
Improvement in tech.
Good weather conditions
Decrease in import prices
Shift of LRAS
LRAS
Price level
Real GDP
LRAS will increase if (pot. Output increases)
1. Quality and quantity of labor increases
2. Improvement in tech.
3. Improvement in quality and quantity other factor of production
Supply side policies
Are the policies of a govt. which brings about a change (shifts) the AS curve and thereby changes the
potential or act. Output.
These policies aim to allow the market forces to act freely with minimum govt. intervention