Macroeconomics

2015-17 (PGP, Term 3)

anubhadhasmana@iimb

Macroeconomics is the study of

an economy as a whole

Macro versus Microeconomics.

Just as a firms or an industrys output and price

depends on the level of demand and supply for its
product, the level of goods and services produced in
the economy as well as the price level in the
economy depends on the level of Aggregate Demand
and Aggregate Supply in the economy.

Just as a firm has some installed capacity and the

potential level of output commensurate with it, the
economy also has a potential level of output that
depends on the level of investment and its efficiency.

Basics of Macroeconomics

Every country has an estimate of the rate at

which it is capable of growing. This is called
Potential GDP growth

This potential to grow is given by two variables:

1. Access to savings and,

2. Incremental capital output ratio (ICOR)

Potential Growth Rate

Incremental capital output ratio :
ICOR capital stock

output

Potential Growth Rate :

g potential capital stock

ICOR

Macro versus Microeconomics

Just as a firm can produce above or below

its installed capacity depending on the
demand for its product, an economy can also
produce above or below its potential output
depending on the level of Aggregate Demand

In the first case the economy is said to be in

a Boom whereas in the second case the
economy is said to be in Recession

Basics of Macroeconomics

Macroeconomic objectives are two-fold:

a. sustained growth in output and,
b. stability in prices

The former implies that we should try to grow

as close to capacity output as possible

The latter implies that this growth has to be

within an acceptable rate of inflation

Basics of Macroeconomics
The Macroeconomic policy tools to achieve
these policy objectives are :
1.

Fiscal Policy and

2.

Monetary Policy

Measuring a Nations Income

Gross Domestic Product at Market

Prices GDP at market price is the
market value of final goods and services
produced with in the boundaries of an
economy over a given period.

Implication 1
Only final goods and services are included in
GDP. All intermediate inputs are excluded
from the value of the final product in order to
avoid double counting.
Ex. A car company (TATA) buys car tires from
the manufacturer of rubber tires (MRF). To
calculate the contribution of TATA to the
countrys GDP we will exclude the value of
tires purchased from the final value of car.

Implication 2
Only goods and services exchanged in the
market are included in GDP. All goods and
services produced outside the market are
excluded from the value of GDP.
Ex. Your services in organizing a cultural fest
for your college (Unmaad!) are not counted
as part of GDP but an event management
company organizing a similar cultural fest
would be regarded as a part of GDP.

Implication 3
Only currently produced goods and
services are included in the GDP. Goods
produced in the previous period and
resold in the current period are not a
part of current GDP.
Ex. Sale or purchase of a new car is part
of current year GDP but sale of a second
hand car is not. The payment made to the
car dealer for his services would be a part
of GDP though.

Economy in a nutshell
Circular Flow of income in an economy
Expenditure

Income

Wages and rental income

Goods and Services

Firms
Labor and Capital

Household
Taxes

R.O.W

Exports

Imports

Payments for goods and services

Public Expenditure

Government

Main Points

Expenditure of one individual becomes income for

another individual in an economy
Measuring GDP through income and expenditure
methods should therefore give us identical measure of a
Nations income
Apart from households and firms, Government is
another source of spending in the economy
In an open economy some of the expenditure by
domestic residents falls on goods produced abroad and
vice versa

Alternative ways of measuring the

GDP

Expenditure Method

Income Method

Output or Value Added Method

Expenditure Method
Nominal GDP
Product
(1)

Current Year
Price (2)

Current Year
Quantity (3)

Value of
Expenditure (4)

Apples

50

20

1000

Oranges

10

50

500

Rice

25

40

1000

Shirts

50

400

Cement

20

30

600

Total

3500

GDP at Market
Price

Expenditure Method
Real GDP
Product
(1)

Base
Year
Price
(2)

Current
Year
Price
(3)

Current
Year
Quantity
(4)

Current
Market
Value
(3x4)

Base Year
Value (2x4)

Apples

40

50

20

1000

800

Oranges

10

10

50

500

500

Rice

20

25

40

1000

800

Shirts

50

400

250

Cement

10

20

30

600

300

3500

2650

GDP at
Market Price

Expenditure Method

Key Expenditure Heads:

Consumption C
Investment I
Government Expenditure G
Net Exports - NX

Income Method
Income approach adds up the incomes accruing
to the various factors of production in the
country, i.e., wages, interest, rent and profits.
Adjustment needs to be made for indirect taxes
and subsidies that create a wedge between the
actual factor payments and the market price
Also, since GDP is a geographical concept, Net
Factor Income from abroad has to be excluded
from the sum of incomes accruing to the
residents

Income method

Republica Economia - A Hypothetical Example

Components of GDP: The Income Approach

BILLIONS OF
RUPEES

1.

Compensation of employees

2.

PERCENTAGE
OF GDP

6,010.0

57.7

Proprietors income

943.5

9.1

3.

Corporate profits

748.9

7.2

4.

Net interest

554.8

5.3

5.

Rental income

142.7

1.4

(+) Depreciation
(+) Indirect taxes minus subsidies
(-) Net factor payments from abroad

Gross domestic product (m.p.)

1,351.3
739.4

13.0
7.1

-85.0

-0.8

10,405.6

100.0

Value Added Method

Value added is the difference between

the value of goods as they leave a stage of
production and the cost of the goods as
they entered that stage.

In calculating GDP, we can either sum up the

value added at each stage of production, or we
can take the value of final sales.

Value Added Method

Value Added in the Production of a Gallon of Gasoline
(Hypothetical Numbers)
STAGE OF
PRODUCTION

(1) Oil drilling

Value of
Sales

Re

50

VALUE ADDED

Re

Income

50

= w+r+p+i

(2) Refining

60

10

= w+r+p+i

(3) Shipping

80

20

= w+r+p+i

(4) Retail sale

100

20

= w+r+p+i

Total value
added

100

GDP at market price versus GDP at

factor cost
As mentioned above, indirect taxes and
subsidies create a wedge between the
cost of factors of production and the
actual market price.
We therefore see two measures of GDP
GDPmp and GDPfc.
Difference between the two is net
indirect taxes

GDP versus GNP

Recall, GDP does not include factor incomes

earned by residents from abroad

Gross National Product (GNP) is the

Value of final goods and services produced by
the residents of an economy over a period of
time (usually one year).

GDP = GNP Net Factor Income From

Abroad

Net National Product = GNP Depreciation

Consump
GDP at
NDP at Indirect
tion of
Factor
Factor Taxes less
Fixed
Cost
Cost Subsidies
Capital
(1)
(1-2)
(3)
(2)

GDP at NDP at
Market Market
Prices
Prices
(1+3) (1+3-2)

Net
factor
income
from
abroad
(4)

GNP at
Factor
Cost
(1+4)

NNP at
NNP at GNP at
Market
Factor Market
Prices
Cost
Prices
(1+3+4(1+4-2) (1+3+4)
2)

3254216

350886 2903330

290132 3544348 3193462

-24920 3229296 2878410 3519428 3168542

3566011

385592 3180419

306963 3872974 3487382

-29515 3536496 3150904 3843459 3457867

3898958

427515 3471443

354226 4253184 3825669

-17179 3881779 3454264 4236005 3808490

4162509

467235 3695274

300458 4462967 3995732

-25384 4137125 3669890 4437583 3970348

4493743

518314 3975429

375574 4869317 4351003

-28889 4464854 3946540 4840428 4322114

4877842

574977 4302865

420286 5298129 4723152

-43083 4834759 4259782 5255046 4680069

From National Income to Personal

Disposable Income
Personal Income To arrive at Personal
Income from National Income we need to
adjust National Income for income earned
but not received and income received but not
earned.
The former include Corporate taxes,
pension contributions, retained earnings
etc., while the latter include welfare
payments, pensions, gifts etc.

Personal Disposable Income

Personal Income =
Net National Product (m. p.)
- Indirect Business Taxes
- Corporate Profits
+ Dividends
-Social Security Contributions
+Government Transfers to h.h.
- Net Interest
+ Personal Interest Income
Personal Disposable income = Personal
Income Direct Personal Taxes

Purchasing Power Parity and

Cross-country comparisons of
GDP

Comparing GDP Across Countries

2013, GDP at Market Price (Current USD)

Source: World Bank

Comparing GDP Across Countries

2013, GDP PPP (Current USD)

Source: World Bank

But there are important

Limitations.
Regional /Sectoral Variations
Inequalities of income and wealth
Economic growth and externalities
Leisure and working hours
The black economy and nonmonetized sectors

Alternative Metrics

Alternative Metrics

Summary
GDP is the summary measure of output
produced in an economy
There are three different methods of
computing GDP
While comparing GDP over time we
need to take remove the effect of inflation
While comparing GDP across countries
we need to remove the effect of
differences in the cost of living

Summary
GDP has serious limitations as a measure
of economic wellbeing and even as a
complete measure of economic output
For a comprehensive view of an economy,
GDP needs to be viewed along with
other indicators of economic
performance